Step 2: Do you want to grow your wealth? and Why Should You Consider Taxes?
Question 1: Do you want to grow your wealth or preserve it? (Select one)
Answer 1: I want to grow my wealth
Answer 2: I want to keep the value of my wealth the same
Answer 3: I’m OK if the value of my wealth declines every year. I’ll just work harder and never retire.
If you chose Answer 3, you can stop reading right away and do something more useful with your time.
What are your options?
There are broadly 3 categories of financial instruments in which you can put your money (called Asset Classes). These are:
All three have their place in your life.
Purpose of cash is to meet expenses in the short-term viz. a month or few months, during which inflation has only a small effect on its value.
If you only want to preserve your money (Answer 2), you should invest in tax efficient fixed income investments (tax efficiency is very critical to fixed income investments as I’ll explain below).
If you want to grow your money (Answer 1), you should invest in Equities.
Why is tax important?
Quite simple. Tax reduces the return you get in hand.
Let’s say you earn 9% interest on your Bank FD. This is good because at 9% you’re about par with inflation and while your money is not growing, it’s at least not shrinking.
But wait a minute. You need to pay income tax on the interest you earn every year. If you’re in the highest tax slab, this is 30.9% or Rs 2.78 on every Rs 9 you earn on your FD. Your return after tax is therefore reduced to 6.22%.
I’m sure you’ve already realized the implications. From an inflation matching 9%, your money is now earning a much lower return and decreasing in value every year.
Fixed Income investments (like Bank FDs) typically tend to match the inflation rate. But after tax, you get much lower return. It’s therefore important to look at the tax efficiency of your investments.
The good thing is that you can choose certain fixed income investments, which attract zero or almost zero income tax. For example: investments in debt mutual funds held for longer than 3 years get an indexation benefit.
With indexation, tax on the return from a debt mutual fund reduces to almost zero, in some cases.
The government thinks that investing in stocks is good for the economy, and therefore investments in Equities get an even more attractive tax treatment.
Income tax is zero if stocks are held for more than one year and only 15% if held for less. Since you should not be investing in Equities for less than 6-7 years, it means that for all practical purposes the return you get in equities is tax-free.
Let’s update the table above with this information.
In the next article in this series, we will talk about why investment duration matters and why this makes equities important.