Tax Season Special: Provident Fund or PF and Voluntary Provident Fund or VPF

All salaried individuals have a Provident Fund (PF) .In India, employers will deduct 12% of the basic salary and put it into the individual's PF account. In most cases, there will be a full employer match. The PF account of the person is tied to the current employer. In case of a change of employer, the individual has to activate the transfer of the funds.

Investment Limits for PF
The PF contribution will be 12% of the basic salary by the individual, and a matching amount contributed by the employer. So unless your salary changes, this amount contributed will not change. In case of long periods of unemployment or leaving the country, the individual must activate withdrawal of funds from the PF account.

Investment Limits for VPF
VPF provides a way for an individual to contribute more funds into the PF which is essentially a retirement account. The individual can specify any amount (upto the entire take home salary) as the voluntary PF or VPF contribution. There will be no employer match on the VPF contribution. Of course, investment exemption can be claimed only for investing upto Rs. 1 lakh.

Lock in Period
This is an employer linked retirement fund. Upon withdrawal before the age of retirement, the interest earned will be taxable.

Return on investment
Currently the interest rate is 8.5% for both PF and VPF. Since PF contribution is mandatory for salaried individuals, I discuss advantages and disadvantages for VPF.

Advantages

• Provides an effective way (through payroll deduction) to increase the retirement kitty. This is especially useful when the basic salary is a relatively small fraction of the total take home pay.
• Interest earned is tax-free. The only other assured return instrument offering tax-free returns is PPF. VPF has a slightly higher interest rate (8.5%) compared to PPF (8%), which can add up to a significant difference over the long term.

Disadvantages

• Individuals with high risk tolerance will find the rate of returns small compared to those offered by ELSS. Smaller lock in periods offered by other instruments offer investors more flexibility in managing their money.
• After every employer change, the funds need to be transferred to the new employer. This process needs initiation, and in some cases, active follow up.

Smart Saver's Verdict
VPF can be effectively used to harness the power of compounding in your favor. If you make significant VPF contributions in the first few years of your working life, the interest on those will keep compounding. These years typically coincide with the low financial responsibility phase for most people. Subsequently, as the need for more funds arises, (such as when you need to start paying off home loans, or after you start a family), the VPF contributions can be stopped.

Tax Season Special: National Savings Certificates or NSC

How to invest in NSC?
NSCs are available at the local post office. Like bank fixed deposits, you can buy NSCs as and when you desire and at any post office in India.

Investment Limits
The minimum amount for NSC is Rs 1,000. There is no upper limit. For amounts greater than or equal to Rs. 50,000, PAN number is required. Of course, investment exemption can be claimed only for investing Rs. 1 lakh.

Lock in Period
An NSC matures in 6 years. After 3 years, some conditional withdrawals are permitted, but the tax penalty will eat away the returns earned during this time. The NSCs can also be pledged ad collaterals while taking loans.

Return on investment
The interest rate offered by PPF is 8%, compounded bi-annually. The interest earned on NSC is taxable.

Smart Saver's Verdict
Before the last rise in interest rates (I am talking of the time in early 2006, before the rates started climbing. Now of course, we are witnessing a descent), NSC was an attractive fixed return investment because of its low lock in period, compared to PPF whose lock in was 15 years. At that time, NSC's rate of return at 8% bi-annually was better than a bank fixed deposit running for an equivalent time frame.

Today, the verdict is in favor of tax saving fixed deposits that have a lock in period of 3 years and equivalent (if not better) interest rates; and hence score over NSCs.

Tax Season Special: Bank Fixed Deposits or FD

How to invest in FDs?
Simply walk into any bank (not necessarily a nationalized bank) and they will do the rest.

Investment Limits
There is no upper limit. Of course, investment exemption can be claimed only for investing Rs. 1 lakh.

Lock in Period
A FD for tax exemption purposes generally has a lock in period of 3 years at present.

Return on investment
The bank will announce this from time to time. At the moment it is in the range 7.5 to 8.5%. The interest earned is taxable.

Advantages
Fixed return on investment.
Lock in period of 3 years. (As of now)
Interest rates compare favorably with those offered by PPF and NSC (as of now)
On maturity, the proceeds can be used for any financial goals, not just retirement.

Disadvantages
Interest earned is taxable.
Individuals with high risk tolerance will find the rate of returns small compared to those offered by ELSS.

Smart Saver's Verdict
At present, the small lock in period of bank FDs makes them score over the other fixed return avenues. However, for the goal of retirement planning, PPF still has an advantage because of its returns being tax exempt. It's about making the trade off between returns and time period of the investment.

Tax Season Special: Public Provident Fund or PPF

Since the tax season is here, I decided to give a description of the various investment options available under Section 80C. Upto Rs. 1 lakh can be exempted from your taxable income. If you are in the 30% tax bracket, this will lead to saving Rs. 30,000. Of course, the returns on the investment are over and above that. Hence this is all the more reason to avail of this provision to the maximum possible extent.

This post deals with Public Provident Fund or PPF.

How to open a PPF account?
An individual can open a PPF accounts in a bank authorized to do so, like the State Bank of India. This account can also be opened in the name of your children. However, each individual can have only one PPF account. Documents to be submitted include PAN card and photograph.

Investment Limits
Once you have the PPF account, you can deposit either a lump sum at a single time or an amount at any number of intervals. The upper limit for investments is Rs. 70,000 and lower limit Rs. 500 per year. This means that you have to deposit at least Rs. 500 every year to keep the account active. Other than this, there is no compulsion to deposit a fixed amount every year; one can adjust the amount depending on the situation in that year.

Lock in Period
PPF has a lock in period of 15 years. After 3 years, some conditional withdrawals are permitted, but the tax penalty will eat away the returns earned during this time.

Return on investment
The interest rate offered by PPF is 8%, compounded annually. As of now, the interest earned on PPF is tax exempt.

Advantages
Assured return on investment, safe instrument.
The interest earned is exempt from tax, though this could change.

Disadvantages
High lock in period
Individuals with high risk tolerance will find the rate of returns small compared to those offered by ELSS.

Smart Saver's Verdict
PPF is a retirement fund; hence the lock in period being high should not be looked at as a disadvantage. Secondly, even the most risk tolerant individuals need to have a fixed return component in their portfolio (in order to make it balanced) and PPF is a worthwhile candidate to consider. As of now, despite its high lock in period, PPF scores over the other fixed return instruments (like NSC, bank deposits) because the interest earned is tax exempt.

The only situation wherein a PPF investment will be ill advised will be when that money will need to be tapped before the end of the lock in period. Of course, unforeseen circumstances can appear in anybody's life, but I here am talking about people who do not have an emergency fund, or who have a major life event (child's education, marriage, home purchase, etc.) coming up for which they need to earmark funds.

Term Insurance is the way to go

Insurance protects us when calamity strikes. Health insurance will reimburse healthcare costs wholly or partially, depending on the nature of the policy. property insurance helps recover the cost of houses and vehicles in case of accidents and natural disasters. When we buy insurance for these causes, we do not expect anything back in case none of the respective eventualities occur. We pay the premiums fully accepting that the money will not be recovered if we do not need to claim the insurance amount. This is called pure cover.

But when it comes to insuring ourselves, most people think that this model of insurance ('term insurance' or pure cover life insurance) is throwing money away. This is the reason why the life insurance market is flooded with endowment (wherein the entire sum insured plus some bonus is paid out at the end of the policy duration) and money back policies (wherein a fraction of the sum insured is paid out at regular intervals during the policy duration). Agents of course are only too happy to sell these policies, the higher the premium, higher is their commission. But once you do the numbers, a different picture emerges.

Let us take the case of a 28 year old female requiring a cover of Rs. 10 lakhs, for a period of 20 years. The premium, under an endowment policy for this works out to approximately Rs. 47,000 per year. At the end of 20 years, upon survival, the insurance company will pay back the Rs.10 lakhs, which was the sum assured.

In case we opt for term insurance, the premium becomes approximately Rs 2,700 per annum. Of course if the person survives the term of 20 years, the insurance company pays back nothing. On the face of it, it looks like we have thrown away Rs. 2700 a year, or Rs. 54,000 over 20 years.

But let us see what happens if we are to invest the Rs. 44,300 ('saved' by choosing a term policy instead of an endowment). Assuming an annual growth of 8% (this is what banks are offering at the moment. you can do much better by investing in equities), at the end of 20 years this works out to a whopping Rs. 24 lakhs which makes the returns earned from endowment pale in comparison. And this is a very conservative estimate.

There is another problem with non-term insurance policies. This example assumes that we had the Rs. 47,000 available annually to pay the premium. Usually the premium required for an adequate meaningful cover works out so high, that most of us will settle for whatever cover an affordable premium will give us. This is a serious risk, as in case of an eventuality, the financial needs of the policy beneficiaries are compromised. After all the very purpose of insurance is to take care of all your financial obligations (dependents, loans, etc.) when you are no longer around to do so.

Bottomline: Insurance is cover and investment is about returns. Manage these objectives separately and both will be achieved.

Tax planning season is upon us

Sometime this month, many of us will get an intimation from the HR/finance departments to submit proofs of various investments so as to avail of tax benefits.

(For those readers who are unfamiliar with what this means, I include a brief explanation. In India, as per the current income tax laws, one can get a tax deduction on upto Rs. 1 lakh, over and above standard deductions. Standard deductions exempt approximately the first one lakh of the income from income tax, slightly more if you are a woman or a senior citizen. The one lakh that I am talking about is over and above that. All you need to do is show that you have invested an amount upto one lakh into certain specified instruments and that amount is taken off from your taxable income. For more details on the instruments comprising this list, read
http://in.biz.yahoo.com/071126/93/6ocdz.html).

So if you have'nt done it yet, invest right away and save tax. Better to do it now, than to rush to do it in the last week of March (plus you lose 3 months for your money to grow). And best of all, when your company deducts the correct amount of tax at source from you (as a result of correctly factoring in all your investments and exemptions), you don't need to wait for a tax refund from the income tax department as well.

DISCLAIMER: I am not a certified financial professional. You are advised to verify all details regarding investment schemes, taxation laws, etc. from certified sources. The intent of this blog is to talk about the values and attitudes related to money management.

Bangalore

A year ago, I was returning from church along with my landlord’s family (Dual income, two kids, one in school, the other in college). We passed by a mall about 10 minutes walk from our building and they asked me if I had been there.

Of course I had been there. Many, many times. To the multiplex where each ticket is a minimum of Rs. 100, even on weekday mornings. Eaten at the food court where a small (and average tasting) icecream costs Rs. 70 and a small cup of steamed corn Rs. 40. Hanged out at the coffee shop where the simplest coffee retails for Rs. 45. Naturally, I could’nt tell them all this. So I just mentioned that I visit the grocery supermarket there and that I consistently find that fresh fruits and vegetables at prices lesser than the local vendors.

By Bangalore standards, I am not extravagant when I visit these multiplexes, food courts and coffee shops. Because that is what software engineers do on weekends and on weekdays after work in this city. That question was a rude awakening for me. A family of four lives, educates its children and saves for a rainy day, on a total income that will be less than the starting salary for a software engineer. And the same software engineers will then complain that they have hardly anything left over to save at the end of the month.

For those of you who did’nt know, Bangalore is India’s IT capital. Many young high earning professionals like me have made it their home. Once known as a pensioner’s paradise, today it is one of India’s most expensive cities to live in. Even a combined post tax income of Rs. 1 lakh per month will keep a dual income, no kids couple firmly in the middle class.

The original population of the city, who are not part of the booming job sectors, obviously have been left out of the glittering malls and shopping arcades that are mushrooming all over the place. The only ones who have benefited are the people who own houses as rental incomes have hit the roof.

I am sure that Bangalore is not the first city (even in India alone) to have experienced this demographic change. However, this highlights the need for all of us to manage our money better, so that we are protected not only from inflation, but also from the vagaries of the job market and urban develoment.

Spending, saving and investing our money optimally is something all of us need to do, irrespective of our ages, family situations or job robustness. Not just in Bangalore.