Personal finances and Tax

Why Tax Sops?

The government gives a variety of tax sops to encourage certain behavior. For instance, the tax savings under section 80 c gives tax benefits for savings up to Rs 1.5 Lakh per year. The idea is to get people to save and invest money. Similarly section 80 ccg gives tax benefits for investments of up to Rs 25,000 for people having income less than 12 Lakhs. The idea is to get small investors to invest in mutual funds so that they get good returns without inordinate risks.

Of course, sometimes the tax sops stop making sense. For instance, on a first self occupied house, a maximum of Rs 1,50,000 deduction is available. But on second or more houses, the deduction available is the entire interest less 70% of deemed rent. In the present scenario, with high interest, high property values and low rents, this second option may be several times the first limit. In other words, it gives very high deduction for people buying a second or more property which does not make sense.

Tax Sops and Financial Planning

While good financial planning takes maximum advantage of the tax benefits, it is not directed by tax benefits only. Good financial plans begin with the needs of the individual and once these can be fulfilled, the optimum tax benefit is taken. Often, however, people make mistakes which can be very costly.

For instance, most of the investment options under section 80 c require the investor to lock in the money 5 years. Schemes like NSC give returns of 8.5% but the interest is taxable. So even considering the initial tax savings, net returns are between 9% and 15% depending on the tax slab. Given that most personal loans and EMI schemes are at 14% to 16% interest rates, this is usually a losing proposition.

Of course, investment in PPF is way better because the interest income is also tax free. But since these are very illiquid (and early withdrawal is again taxed),  one needs to think carefully before investing in them.

Rules of thumb

If you are in the 10% tax bracket, then do not invest in tax saving schemes like traditional insurance and NSCs. If you are very certain that you will need money for 20-25 years, then invest in PPF.

If you are in the 30% tax bracket then you should completely meet the limit in section 80 c. Most of it will probably be covered by EPF and similar instruments. Also, you should not require to buy things (except house) on EMI.

If you are in the 20% tax bracket, then the difference between the two options are not significant. But if you do anticipate need for money in a couple of years, then it is better to not invest in locked up schemes.

Privacy, market decoupling and REITs

Real estate market in India is currently claimed to be in bubble territory. Certainly, the price increase during the boom period of 2004-2015 is unprecedented. While it has been a wonderful time for people who got on board before or in the initial stages of the boom, for people who did not purchase a house, it seems pretty hard. Worse, these are the people who are most likely to buy property at the worst possible time - just before the bubble explodes.

Privacy and market decoupling

So what has this got to do with privacy? Well, as per the original definition, a private citizen was one who took no interest in the affairs of the society. Given that most of the functions of a society are performed by markets today, I would call privacy as the degree to which a person is decoupled from markets.

When a person rents a house on a one year lease and license agreement, he or she is highly coupled with the market. Price changes would affect him greatly. The coupling decreases as the lease term increases and price stability is built in; however, often the "price stability" assumes other factors to remain constant. For instance, a 10% escalation clause would be fine in high inflation (and high salary rise) era but if inflation drops to 2% and salary increases follow suit then again issues arise.

Owning the house you live in significantly reduces the risk. You become much more disinterested in what happens to property prices.

Ticket size and Timing risk

Unfortunately, while owning a house reduces the risk associated with market movement, the process of owning a house increases it. In other words, if you purchase a house when the prices are high, you are significantly worse off. The real issue is that you can never be sure when the prices are high or low and since you must purchase the house at one go, you need to take up this one time risk

REITs

It is easy to see where all this leads to. REITs are a mechanism to "buy a house one square foot at a time". Basically a REIT (real estate investment trust) is a large corpus of funds that is invested in real estate. The investment into this corpus can be bought and sold in "small quantities". Sure, this costs money and my sense is that for REITs, the costs for managing REITs are likely to be 2-3% which will probably be of the same order as rents so your returns will be substantially lower than if you had bought a property. However, the benefits of diversification and small ticket size are significant since for many people there will be no other option.

In other words, once well managed REITs are available, you can invest in them in small amounts. They will allow systematic investment in property. For a person who has just started a job and would like to buy a house in 5-6 years, REITs would give an alternate mechanism to "decouple from the market". By investing a fixed amount every month, one can get rid of the fear of "what if property prices increase substantially". When one is ready to purchase property, one can just sell the investment in the investment in REITs and purchase the property.

For people who dislike paying interest and / or are not certain where they want to live in (probably because they are considering changing their job, career or city), these will be a boon and an alternative to purchasing a house on EMI.

Alternative to EMI schemes

EMI schemes and personal loans are the best justification for planning your personal finance. Hence planning your finance is an alternative to them - and a very profitable alternative. This post is for those people who dont seem to every have money with them when they want to buy something and as a result keep resorting to EMIs.

Cost of debt

Let us look at what the implications of EMI are. Consider purchasing a phone worth 8,000 Rs at a 6 month EMI of Rs 1400. This is fairly representative scheme and you may image that it is not very costly. But in fact, it costs you Rs 400 and the interest rate is just around 17%. Similarly, the interest rate on personal loans comes to anywhere between 14% and 16%. Credit card debt is even worse at 24%-36%.

If an EMI is taken as a one off case then it may not seem costly but the reality is that taking things on EMI is usually a sign of bad habits that cause recurring problems.

Planning

The first benefit of planning is that it avoids impulse buying. You may be tempted to buy stuff that you do not need on EMI since the gratification - the reward of buying is instant but the costs come over the next few months. However, if you pay in cash (or by debit card), you will need to plan before making large purchases - and in the process you will have to ask yourself whether it is really worth the money or not. In the cool and comfort of your home, away from the glitz of the shop, as you weigh the options, the unnecessary purchases will be avoided and things that matter most to you will remain.

The second major advantage of planning is that you save a LOT of money. 400 Rs may not seem like much, but if you make a purchase every month, it quickly will. Worse, when you use EMIs for small things like a washing machine, you will also use it for larger things like a car. THAT can easily put you back by a whopping 25,000 Rs. Don't believe me - do the maths yourself.

How to plan

Systematic planning involves a lot of steps but for now we will just begin with a quick a dirty plan - but one that is better than no plan at all. First of all, you need to have a budget for shopping and capital purchases. This will include almost every item sold in the glitzy stores in a mall for instance clothes, shoes, accessories, electronics, furniture, furnishings and so on. Note that as a rule of thumb, the budget should be between 10% and 20% of your take home salary; begin with 10% and try to keep it there unless and until you have to increase the budget.

Now keep atleast half of you budget in a "fund" - a piggy bank is the best idea. Whenever you have the impulse to buy anything, just add it to you wishlist. Put money into your fund every month immediately after getting your salary. At this time you can also check you fund value and decide if there is anything you would rather buy from you wishlist or wait till your fund increases.

Of the remaining money, add a fourth to your wallet every Monday and feel free to use that amount - and only that amount to "splurge".

So for a person who earns 20,000 Rs per month, the monthly budget is Rs 2,000. Of this 1,000 will go into the fund and every week he will add Rs 250 to the wallet for spending.

As you go about this you will initially spend the the money in the first 2-3 day itself and will feel miserable the rest of the week, especially on weekends. Over time, if you keep at it, you will learn to keep waiting for all of the weekdays so that you can have a good weekend. If you really want to become a pro, you can try saving something from the 250 Rs (say 50 Rs) so that once a month you can have a better party.

If the budget of seems too low - even after taking it all the way upto 20% of your take home, you need to take a hard look at your overall planning which we will do in the next post.