This is part 2 of the article: Tax saving investments and financial products: PPF, ELSS and more. Please read the first part before continuing with this one.
Basically, such ACCUMULATION schemes like PPF should be considered only for a PURPOSE – in case you know you will have to meet so and so expense after so many years time.
The best scenario example that I can give where PPF is effective is to secure your kid’s college education fee. Make calculations considering the worst case scenario – assume a PPF interest rate of 6% only (2% below the current rate of 8%). Calculate how much you may need after 15 years – it is difficult, but you will have to make some estimate. Say you believe you may need around 3 lakh Rs. when your kid is eligible for college admission. Make calculations to see how much investment in PPF is required each year to secure this 3 lakh Rs. after 15 years at 6% interest rate. You will arrive at approximately 10,500 Rs. as annual investment in PPF. Start off the investment such that the maturity matches with the time of your kid’s admission. Don’t just look at PPF as a tax-saving investment. That’s what I advocate in all my articles – Concentrate on the PURPOSE of your investment, let tax-saving and other benefits come as an add-on by-product. What we end up doing is looking at the by-products and we forget the purpose. The best part of such interest based financial products is that you atleast have a clear idea of how much you will earn over a period of time. In stock investments, there is always uncertainty. Say you make a similar investment in stocks for 15 years. The market keeps going up and up for 13 years, while it falls miserably in the last 2 years – the returns will be impacted severely, and will not serve the purpose. So always look at any investment with the primary focus on what you want to achieve.
A simple way to explain this is that both PPF and NSC (National Saving Certificate) are exempt from taxes. Both are offered by government and are risk free. Still PPF is giving 8% interest rate while NSC only 6%. The reason is that different products are available for different purposes and duration. NSC matures in 6 years and hence gives less interest; also the interest earned is taxable in NSC, which is not the case in PPF. Despite being offered by the same government, these 2 (and many other instruments) are available for different purposes.
Now you may say that insurance policies promising fixed maturity amounts also serve the same purpose and give benefits for tax. Actually, the problem with insurance policy is that a significant portion of your invested money goes in commission. The best way to gauge whether PPF is better or Insurance policy is to make calculations – how much you pay for each and how much you get back on maturity of each. PPF returns will always be higher than those from the insurance policies.
You can also have tax-saving as your purpose. Then PPF or NSC is a very good and reliable option. But make sure you assess your situation well. Save tax only if you do not have any financial commitments like loans. Even the cheapest housing loans with compounded effects cost more than 11% per annum. What’s the point in saving tax (10%/20% or 30%) by investing 10K and locking the money for a long horizon. What we don’t see is that 10K invested today may give a ONE TIME tax benefit of maximum 30% or 3K. But the same 10K used to prepay loan will prevent ATLEAST 11% each year for the entire duration of loan, which may be anywhere from 1 year to 30 years. The compounded effects will be much more useful for this interest saving on loans, as opposed to what you gain in interest and tax saving in tax saving instruments.
This discussion will be incomplete without a comparison with ELSS and other tax-saving scheme. These topics will be covered in the forth coming articles.
Keep visiting this blog for further content.
Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.
You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.
7 comments:
Opening PPF accounts with SBI has totally done away with the hassles of withdrawal of amounts from PPF accounts. Also you can withdraw and deposit on the same day between 1st and 5th for availing tax rebates without losing on the interest front. One can withdraw upto 50 % of the balance 3 years prior to the date of withdrawal after the account has attained 6 years. The entire money is tax free is a very big advantage. Another point is that the account can be extended for further blocks of 5 years. The compounded amounts on maturity are often quite large to take care when the person retires and the expenses are high.
Certainly the point which needs to be understood before investing in any instument is to totally clear off all dues and all loans as far as practicable.
Dear Sobhit, Could you please explain the parameters to be taken into account for discriminating between any two stocks at a given point of time for arriving at an investment decision from the secondary market.
Your articles are extremely enlightening and educating in nature. The language used is so simple that any novice can understand.Congrats and please keep up the good work.
Thanks.
Hi,
I found this article very usefull and encourging to use risk free investment instrument. However i have difference of opinion on paying loan vs investment. we need to start investment early and opening PPF account very early in career stage helps in eating up lockin period earlier. Generally home loans are for 15-20 years which spans normal earning life. If we do not invest and keep on concentrating on paying loan only, we will lose time and oppurtunity. One more thing, let us say if i am paying interset of 1 Lakh rs on which i get 30000 tax rebate. So effectively i am paying 70000 rs as interset. If i can accumulate my PPF amount such that i start getting 70000 interset in my account every year, home loan will be completly nullify.
Thanks
Chetan
Dear Shobhit,
Thanx a zillion for trying to educate the duds like me in finance!
After reading your blog "Tax saving investments and financial products: PPF, ELSS and more "
I felt intrigued by my friend's rather typical case, and whether he should invest in a balanced fund, or in an ETF or prepay the housing loan as recommended by you( which is not in his name but in the name of HUF, of which he is the karta).
The HUF derives a rental income and the housing loan is also in HUF's name incurring interest of 11.5%, monthly compounding. The balance outstanding as on date is Rs.602032.35
The EMI is Rs. 15218/- The total interest payable during CFY (though variable rate)is Rs.67485/-
There are no prepayment penalties if up to 20% of outstanding amount is prepaid in any given year.
The HUF already makes a "saving" of Rs. 100000 /- pa by repayment of principal
My friend, the Karta has an independent income falling in the tax bracket of 30% and his savings on own account are (commited )about 70 k for taxation purposes. He has no loan in his name.
The liability of repayment of housing loan is on the Karta, as the HUF earns a rental income which he uses.
The interest on housing loan gets deducted from the rental income of the HUF (about 4.65 lakhs per annum). Now, the question is whether this Karta of the HUF should invest the amount in a balanced tax saving equity fund or in an ETF or prepay the loan to the extent. At the current rate of repayment, the loan gets paid up by Sept 2011 without prepayment and by July 2011 if Rs 30000/- is prepaid.
Calculations reveal that the saving by prepaying the 30000 in this August itself yield " become" Rs. 47818 over four years period.
This translates to a return of Rs.17818 or a simple return of 14.8%
The HUF falls into a tax bracket of 30% I think but am not sure of this; it could also be 20%
Intt payable during CFY without prepayment = Rs. 67485 fully deductible from rental income Rs. 65106
Therfore, additional taxable amount when prepaid = 2379
Tax @ 30% on this is Rs.713.7
Thus net returns (neglecting cess etc.)Rs. 17104.3
or , on a simple interest (average asyou often put it) 14.25% pa
Now, let us calculate his returns if he invests in an ELSS, this very same amount
Again assuming the investment in this August it self.:
For want of any other known yardstick, I used the NAV of the Balanced Fund of ICICI Pru Pension Plan which I had taken for my self about four years ago (as you did too).
I have used the NAV of 3rd August, 2006 and 2007 respectively;
NAV as of 3rd Aug 2007 (after markets corrected): Rs 23.96
NAV as of 3rd Aug 2006: Rs.19.99
Appreciation over one year Rs.3.97
Or, in % terms, 19.86%
Considering that this was a bull phase, let us just use 40% of this rate for the coming four years
which is very conservative to my mind, considering all 7.94%
Amount assigned to MF tax saving type Rs30000
One time tax saved:Rs9000
Amount actually invested after commissions etc: Rs29250
returns with annual compounding at the above rate:Rs. 10461.7887
returns with simple interest at the above rate: Rs 9294.447224
Net return non taxable, minimum including tax saved Rs. 18294.45
In percentage terms, this would be =15.25 % pa
The returns would be higher if he also invested the 9k tax saved say in an ETF.
The lock-in period is also only 3 years.
I have given all relevant details, I presume and have tried to in accordance with your calculation methodology.
I would appreciate if you (or any of the readers) could point out any flaw, fallacy or mistake in either the calculations or assumptions made.
Dear Shobhit,
My case is just hopeless and I feel no redemption is possible! Only miracles. I am on verge of retirement by next month end with a paltry kitty of ~Rs. 8.00 Lakhs and a measly pension of Rs 8500/- per month.No other savings except the pension plan mentioned above and about 50 K in Infra tax saving bonds and NSC's. I wonder what advice could you have for me except slogging it out post retirement also.
Was planning to invest the money in MF's prior to reading your blog but am now more confused then ever!
Forunately, I live in my parental house for which no rent is payable.
Hi Nandkishore,
If you can clearly state your question, i may be able to answer it precisely.
The other anonymous reader who has left a long comment, please also include your name so that I can respond specifically.
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