Debt Funds - The Tax Warrior against FDs

Fixed Deposits have long been associated with assured returns for most of our contemporary and previous generation population. A “tension free” return of 8-10% has meant the holistic investment planning for many of us. But this “tension free” return comes at a huge cost in the form of ensuing taxability. Below is an illustration how Taxes eat into our FD returns.

                                                             

Annual Interest on FD		10%	20%	30%
	8%	7.2%	6.4%	5.6%
	9%	8.1%	7.2%	6.3%
	10%	9.0%	8.0%	7.0%

* If you feel difference of 1-2% is nothing you might want to know about power of compounding

So as the above illustration shows, net return of FDs keeps on decreasing with rise in applicable tax bracket, making the ‘safe’ return of FDs even lower. There are two more points to take note of as far as taxation of FDs is concerned:

1.     One has to declare interest earned on FDs every financial year irrespective of investment or maturity date of the FD. E.g. you make an FD in Dec’12 for three year duration, so you are supposed to declare interest accumulated in the financial year 12-13, 13-14 and 14-15 separately in the respective financial year income tax return.

2.     Contrary to popular perception there is no tax free interest on FDs. Some people think that interest earned upto 10,000 in a financial year is tax free. But reality is that limit is for saving account interest only, not FDs.

So is there is any alternate which is as safe and more tax efficient ?

Yes there is and its known as Debt Funds.

Before exploring how Debt funds are more tax efficient than FDs, lets first explore what Debt funds are.

Banks offer FDs for raising money, in the same manner companies offer different Debt instruments like Commercial Papers, Debentures, etc to raise money for their capital needs. Following is the nature of these instruments –

• Rated by independent rating agencies like CRISIL etc for their creditworthiness
• Intermittent in nature – Unlike bank FDs they are not available for subscription continuously. Companies offer them only when they need capital for some specific or general working capital requirement.
• Rate of Return offered by these instruments depend on the ratings. So higher is the rating, lower is the rate of return

Debt funds function in below manner –

1. Mobilise money from retail investors like me and you
2. Invest the money thus collected in different debt instruments like the ones defined above, apart from government bonds , money market instruments etc.
3. Allocate ’Units’ to investors based on their quantum of investments
4. Payback money to investors when they redeem their investments

Now coming to taxation part, Debt funds score over FDs because you can use Inflation to pare down your returns for tax calculation. Instead of going into theory, lets try to understand it by an example -

*Capital Appreciation considered for Tax Calculation

Fixed Deposit = [(D) - (B)]

Debt funds = (D) - [(B) *[(Inflation Index during (D)/Inflation Index during (A)]

Inflation Index = A parameter based on ensuing inflation for respective financial year , declared for every financial year by government.

Redemption = Process of taking out investment

Capital appreciation = Amount considered for calculating tax

Returns After Tax = Returns realized after paying applicable tax

So as we can see from above example, even though a Debt fund’s returns were supposed to be lower than a FD, in reality it gave better returns because of lower taxation.

But above taxation is applicable only if investment is made for more than 3 years, otherwise it remains same as that of FD.

Wait for our next article to learn What are types of Debt funds and how to invest in them.

Inflation Index i.e. Cost of Inflation Index (CII) is as below for different financial years –

You might also like to read about my perspective about Financial Planning. And as always thanks for reading and if you like it shout out :) help your friends by connecting him/her to us via facebook or email : healthynivesh@gmail.com

Sukanaya Samriddhi Scheme- For the Luxmi of the Family

India is a country of ironies. This phenomenon gets manifested in worst manner possible in our attitude towards our girls. While we worship female form as a manifestation of power (Durga), love (Radha), money (Laxmi), knowledge (Saraswati) and lot more, we also sadly have one of the worst gender ratio - thanks to rampant female foeticide and infanticide.

It is to counter this harsh reality that government has introduced Sukanaya Samriddhi Scheme , which aspires to provide a secure, long term and ASSURED investment option for girl child. Lets have a look at the details.

Eligibility

Account can be opened subject to following conditions -

• In the name of girl child up to 10 years of age
• Maximum of one account per girl child
• Maximum of two accounts by one set of parents – third account can be opened provided two the girls children are twins or all three are born together.

Account Opening

Following documents are required -

• Birth Certificate of girl child
• ID and Address proof of the guardian of the child-who will operate the account on her behalf till she attains the age of 10 years, after which both guardian and girl child can operate the same
• Account can be opened either in a post-office or PSU bank
• Account can be transferred all over India in case account holders shifts her base

Rules

1. Minimum contribution of Rs. 1000/- in a financial year
2. A penalty of Rs. 50 if minimum contribution not made in a year
3. Maximum contribution of 1.5 lakhs in a year
4. Deposits can be made only for a period of 14 years from the date of account opening
5. No deposits shall be accepted from the 15th year of account opening

Withdrawal

• Permitted upto 50% of total amount when girl child turns 18.
• Fully withdrawable when girl turns 21 or when she gets married, if she get married before turning 21.
• After girl turns 21, account can be closed, otherwise it will continue getting interest on the accumulated amount, but no more deposit will be accepted.

Interest and Taxation

• For the current financial year, government has declared 9.1% as annual interest rate
• Full amount deposited under the scheme is tax exempted under Section 80(C)
• All the interest income on the deposit is also tax free
• The amount withdrawn from the account is also tax free

To summarise the scheme provides a very lucrative option for parents of girl child, but as always this scheme has to be analysed for the suitability in a holistic manner instead of temptation of promised high returns. Against the pros of High assured rate of return and Tax benefit , cons score in the form of illiquidity and hardship of facing PSU banks , which are most of times not willing to help even for smallest of the work, leave alone account opening.

Ever wondered why for some people PPF and Sukanya Samriddhi are best investment while for others it is Equities- Risk is the answer. Know your risk here. We do individual investment advice as well. Write to us at healthynivesh@gmail.com. For weekly investment advice like us on facebook. We promise we won’t spam :)

Liquidity: The Oxygen equivalent of money

Investing is like running a marathon. Long run, really really long run. But money is not a sport where you know with absolute surety about requirement being some distance away. Sometimes need of money can be predicted well in advance but many a times, sudden need for cash may arise due to unforeseen circumstances. Life events like Job loss, medical emergency, natural disaster or law enforcement issues may mean cash is required right than. Effects of most of these emergencies can be mitigated using insurance but insurance claim is a fairly long process which most times is based on reimbursement and hence you have to pay cash from your pocket (mostly savings) first. It may not be very easy to convert savings stashed in PPF, NPS or real estate etc to cash. This ability of an saving to be able to converted in cash on demand is called as Liquidity.

Liquidity is mostly a neglected aspect of savings. People talk about expected returns and risk, sometime tax implications as well but mostly ignore liquidity. But liquidity becomes most crucial aspect in emergency circumstances. Imagine all your wealth being locked out in real estate and when you need money. You can not sell property in a day or two, hence you will need to take loan. Which will be very expensive. Personal loans cost more than 14% per annum and in case of no regular stream of income even they may not be available. You will have to sell property in distress and may not be able to realise its full value. Sometimes distress sale results in lower valuation of up to 70-80%. That is equivalent to losing that much wealth only because of liquidity. So it just sums up why ensuring some of the investment in liquid instruments is necessary.

Traditionally investments are classified as 2 types as far as liquidity is concerned

Liquid investments:

These are all the stuff which can be converted in cash at very short notice. Best of all is savings bank account. Other instrument includes Gold, Bonds and debt and equity funds which do not have any lock in period and equities which are traded well on stock market. Most of these things can be converted in hard cash at a very short notice. But we divide this kind of instruments in 2 parts

1. Instruments with low risk: It will involve liquid investments which also have low risk. It means you can convert investment in cash on a value which is largely in line with your expectations. For example in short term sovereign bonds or sweep in FD’s, there is virtually no possibility of capital loss even if you have to take money out at a very short notice
2. Instruments with high risk: These instruments are liquid but comes with moderate to high risk. Long term sovereign bonds, corporate bonds, mutual funds and equities comes under this category. One should consider these instruments as fairly illiquid due to risk manifested in them. It may be possible that when you need money, equity market are in a stress and you have to sell your investments at a discount as much as 30-40%. While some high risk investments are theoretically liquid, due to murphy’s law they tend to cash out during time of distress in the market and hence at a considerable loss.

Illiquid Investments:

As name says these are the instruments which can not be converted to cash easily. These are both paperless Investments with lock in period like PPF, Fixed FD’s NPS, ELSS etc and physical assets like Real Estate and vintage things like paintings, old wine (Yes these are investments), collectible items etc. It is very difficult (virtually impossible) to dispose of these investments in short duration of time.

Financial world is too complicated to such simple classification, so there are other products which are supposedly illiquid but provides some flexibility like FD’s with overdraft facility. This is basically an arrangement of FD with a facility to draw a loan on it with some additional cost. So if Interest rate on FD is 9% bank agrees to give a loan of upto 70-80% of that amount for 10.5-11% interest rate. You can repay that loan according to your convenience. Similarly PPF allows you to withdraw your corpus in some special circumstances like medical emergency, to buy a home etc. Some other instruments have tax implications if premature.

Another important aspect related to liquidity while investment planning is liquidity is not a key consideration after a certain amount of money is in liquid instruments. As a thumb rule most of the advisors advise it to be 6 months of monthly expenses but I do not believe in thumb rules in investing. They are just good benchmarks which anyone can use to make intelligent decisions.

In end liquidity is an important consideration while investing and that is why liquid investment come at a premium to investor or stating it other way round illiquid investments generate better returns over a long period of time.

Another important factor while making investment decisions is risk, read about it here. Let us know what do you feel about liquidity in comments.

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