Every time I speak to someone about taxes, I am amused. Not sure whether it is their lack of common sense, or it is about the herd. I have seen this pattern even with qualified professionals. They seem to independently think less, and follow more.
To follow is normal for humans though. Look at the mutual fund industry. Most fund managers have this dilemma, to research and act, or to just be part of the herd. The reward is complicated. If they act independently, but lose money, it is a disaster both for their reputation and career, never mind the investors. If they follow what other fund managers do, but lose money, they get to retain their jobs. It is a no-brainer then to make the choice.
To follow is normal for humans though. Look at the mutual fund industry. Most fund managers have this dilemma, to research and act, or to just be part of the herd. The reward is complicated. If they act independently, but lose money, it is a disaster both for their reputation and career, never mind the investors. If they follow what other fund managers do, but lose money, they get to retain their jobs. It is a no-brainer then to make the choice.
For individuals, though, there is no such pressure; yet, that perverse behavior shows up from nowhere. Take taxes: there is no riddle in dealing with them. What is important is long term aftertax cash flows, not lower current taxes. Whether you are an employee or a business owner, the equation is the same. People forget about the long term impact as it is not as clear as short term is; and they look at their current year tax savings. So how do we plan our taxes? Let's slice it down in the Indian context, though the approach is the same in the US and elsewhere.
The essentials
First one is to take a term cover for life, not an endowment policy. In India, the premium paid is tax deductible. Therefore, people tend to take new endowments almost every year. It is as idiotic as it can be. Life cover is not dependent upon tax policies of the government. It is imperative for every one who has dependents whether or not there are tax savings. The same is true for medical cover. Just take one based on your requirement irrespective of taxes. You cannot be without having one; so there are no discussions here.
How much do you have to be covered for life and medical is a matter of judgment. You need not consult advisors for that. Use your common sense and choose. Think about what could happen if there is no cover at all, the likely financial consequences, and so forth. Then select the cover that suits your pocketbook.
In cash you trust
After that you have cash for investments. Put it where you feel you are most secure. However, know the consequences of investing in one instead of the other. It is always a trade-off: choose where the opportunity cost is the highest and stress levels are the lowest. Throw some cash in risk-free assets. These are the ones backed by the government, and are denominated in the local currency. In India, you can look at the public provident fund, RBI bonds, and even bank deposits. You have to have faith in the banking system, and assume that the depositors' cash is protected, which is mostly true even for private banks.
Again, how much to throw it in there is left to your judgment. What are your ideas about cash, bonds, and equity? Do you understand each game sufficiently enough? It is always good to have aftertax returns that supply stable, albeit low, almost risk-free cash flows. At the end of the day, you got to be able to sleep well. If you are going to be worried about your investments in equities each night, something is wrong. Move the allocation heavier to the other side if that's what you want.
Because you are trying to safeguard your emotions and stress levels, which is vital, there are no tax considerations in choosing these low-yielding investments. If you consider that after being in cash, there is either little or no money available for other investments, there is a solution.
But before that you need to know the real consequences of being in cash. Cash is a fixed currency investment, which is constantly under attack by that silent monster called inflation. Suppose you feel that say, Rs.10 m in cash is a stress-free bet, there is a double whammy in waiting. First, although interest income changes based upon the prevailing interest rates, its purchasing power diminishes year after year. Second, your cash investment remains fixed assuming you spend entire income each year. You will still have that Rs.10 m at the end of each year; the problem though is that its purchasing power comes down to Rs.5.60 m in present value terms at an annual inflation rate of 6% after 10 years; in 15 years, it reduces to Rs.4.20 m; and so forth. So if your allocation is mostly cash, you have to have lots of cash.
Now, back to the solution; in fact, it is more of a consolation. Remember it is about the trade-off: reduce your expenses. You can live well enough if you don't go out for food, don't buy expensive coffee, buy a smaller TV, use a cheaper smart phone, and so forth. There is fun in watching sunrise and sunset, cycling, beach, fooling around with friends and family. Much fun in life is often free or low cost. You know what I mean now.
Bonds
If you have more cash left, you can consider corporate debt. Buy them through debt funds, or traded bonds through stock exchanges. India does not have a thriving corporate bond market, unlike the US. So it is easier to use debt funds. Tax considerations do matter for debt investments; so read up on them. I wouldn't advise using an advisor here either. If you cannot understand even after reading about them, skip the investment, or at least defer it until you get it.
Here's the summary, but beware the laws change quickly; do your own research to stay abreast. Debt funds come in two forms: dividends option and growth option. The dividends option debt funds distribute dividends (they are called dividends although come from interest received by debt funds from their debt investments) at regular intervals. But the fund has to pay dividend distribution tax on the payouts; this is as high as close to 29% as of now. These dividends are not taxed at the hands of individuals again; some sanity. The growth option lets your share of potential dividends reinvested in the fund assets since there aren't any distributions.
So the math is simple: if your tax rate is much higher than the dividend distribution tax rate, go for the dividends option; if not, go for the growth option. But don't paste it in your mind; when laws change, you got to change your mind too.
I think short term capital gains (less than 3 years) are added to your income and taxed at the marginal rates. If your tax rate is 25%, and capital gains are 100, aftertax gains are 75. You have to check whether you are happy with aftertax gains. Long term capital gains are taxed at either 20% based on indexation, or 10% without indexation. Do some research on indexation, and find out if it is helpful to save taxes.
In summary, when you choose debt, you have to think about taxes. Debt funds tell you that they can give you returns higher than say, bank deposits. You can check whether it is true, and suits you. Liquid funds are far better in terms of meeting expected returns than other debt funds where returns are based on changes in interest rates and stability of corporate cash flows. Liquid funds are like cash though. I wish there was a more mature debt market in India where individual investors could buy and sell corporate bonds as they pleased.
Equities
After all, long term wealth is created only through equity investments. Either start a business of your own, or own part of an existing business. Buying equity index or individual stocks can lead you to that path. Not much time is required to think about taxes here. In India, short term capital gains are taxed at a flat rate of 15%, and long term capital gains are tax exempt. Dividends from stocks are also not taxed until they exceed Rs.1 m. Check again, laws change without noise and notice.
After your cash investments are made, your stress levels are taken care of, and your good night's sleep is assured, all cash, month after month, year after year, should go to equities. If you understand them and have time to do research, pick stocks directly; otherwise, throw the cash in the broader index.
Taxes
I am not sure why people get excited about taxes when it really does not require much time to plan at all. Sure, if you are an individual business owner, you may have to spend a little more time in tax planning; in that case, employ or consult tax advisors. If you have invested in properties and have capital gains, you may have to read a bit more about taxes on capital gains; just a little bit more time.
Don't go wild on taxes and complicate the matter; for it is not. And when the country is allowing you to earn your income, it is your obligation to pay up taxes due on that income. I know people who fret about paying even 10% on their income. Heck, when the tax laws are so friendly for the long term wealth creation, it is meaningless to try to evade or fight the system.
The essentials
First one is to take a term cover for life, not an endowment policy. In India, the premium paid is tax deductible. Therefore, people tend to take new endowments almost every year. It is as idiotic as it can be. Life cover is not dependent upon tax policies of the government. It is imperative for every one who has dependents whether or not there are tax savings. The same is true for medical cover. Just take one based on your requirement irrespective of taxes. You cannot be without having one; so there are no discussions here.
How much do you have to be covered for life and medical is a matter of judgment. You need not consult advisors for that. Use your common sense and choose. Think about what could happen if there is no cover at all, the likely financial consequences, and so forth. Then select the cover that suits your pocketbook.
In cash you trust
After that you have cash for investments. Put it where you feel you are most secure. However, know the consequences of investing in one instead of the other. It is always a trade-off: choose where the opportunity cost is the highest and stress levels are the lowest. Throw some cash in risk-free assets. These are the ones backed by the government, and are denominated in the local currency. In India, you can look at the public provident fund, RBI bonds, and even bank deposits. You have to have faith in the banking system, and assume that the depositors' cash is protected, which is mostly true even for private banks.
Again, how much to throw it in there is left to your judgment. What are your ideas about cash, bonds, and equity? Do you understand each game sufficiently enough? It is always good to have aftertax returns that supply stable, albeit low, almost risk-free cash flows. At the end of the day, you got to be able to sleep well. If you are going to be worried about your investments in equities each night, something is wrong. Move the allocation heavier to the other side if that's what you want.
Because you are trying to safeguard your emotions and stress levels, which is vital, there are no tax considerations in choosing these low-yielding investments. If you consider that after being in cash, there is either little or no money available for other investments, there is a solution.
But before that you need to know the real consequences of being in cash. Cash is a fixed currency investment, which is constantly under attack by that silent monster called inflation. Suppose you feel that say, Rs.10 m in cash is a stress-free bet, there is a double whammy in waiting. First, although interest income changes based upon the prevailing interest rates, its purchasing power diminishes year after year. Second, your cash investment remains fixed assuming you spend entire income each year. You will still have that Rs.10 m at the end of each year; the problem though is that its purchasing power comes down to Rs.5.60 m in present value terms at an annual inflation rate of 6% after 10 years; in 15 years, it reduces to Rs.4.20 m; and so forth. So if your allocation is mostly cash, you have to have lots of cash.
Now, back to the solution; in fact, it is more of a consolation. Remember it is about the trade-off: reduce your expenses. You can live well enough if you don't go out for food, don't buy expensive coffee, buy a smaller TV, use a cheaper smart phone, and so forth. There is fun in watching sunrise and sunset, cycling, beach, fooling around with friends and family. Much fun in life is often free or low cost. You know what I mean now.
Bonds
If you have more cash left, you can consider corporate debt. Buy them through debt funds, or traded bonds through stock exchanges. India does not have a thriving corporate bond market, unlike the US. So it is easier to use debt funds. Tax considerations do matter for debt investments; so read up on them. I wouldn't advise using an advisor here either. If you cannot understand even after reading about them, skip the investment, or at least defer it until you get it.
Here's the summary, but beware the laws change quickly; do your own research to stay abreast. Debt funds come in two forms: dividends option and growth option. The dividends option debt funds distribute dividends (they are called dividends although come from interest received by debt funds from their debt investments) at regular intervals. But the fund has to pay dividend distribution tax on the payouts; this is as high as close to 29% as of now. These dividends are not taxed at the hands of individuals again; some sanity. The growth option lets your share of potential dividends reinvested in the fund assets since there aren't any distributions.
So the math is simple: if your tax rate is much higher than the dividend distribution tax rate, go for the dividends option; if not, go for the growth option. But don't paste it in your mind; when laws change, you got to change your mind too.
I think short term capital gains (less than 3 years) are added to your income and taxed at the marginal rates. If your tax rate is 25%, and capital gains are 100, aftertax gains are 75. You have to check whether you are happy with aftertax gains. Long term capital gains are taxed at either 20% based on indexation, or 10% without indexation. Do some research on indexation, and find out if it is helpful to save taxes.
In summary, when you choose debt, you have to think about taxes. Debt funds tell you that they can give you returns higher than say, bank deposits. You can check whether it is true, and suits you. Liquid funds are far better in terms of meeting expected returns than other debt funds where returns are based on changes in interest rates and stability of corporate cash flows. Liquid funds are like cash though. I wish there was a more mature debt market in India where individual investors could buy and sell corporate bonds as they pleased.
Equities
After all, long term wealth is created only through equity investments. Either start a business of your own, or own part of an existing business. Buying equity index or individual stocks can lead you to that path. Not much time is required to think about taxes here. In India, short term capital gains are taxed at a flat rate of 15%, and long term capital gains are tax exempt. Dividends from stocks are also not taxed until they exceed Rs.1 m. Check again, laws change without noise and notice.
After your cash investments are made, your stress levels are taken care of, and your good night's sleep is assured, all cash, month after month, year after year, should go to equities. If you understand them and have time to do research, pick stocks directly; otherwise, throw the cash in the broader index.
Taxes
I am not sure why people get excited about taxes when it really does not require much time to plan at all. Sure, if you are an individual business owner, you may have to spend a little more time in tax planning; in that case, employ or consult tax advisors. If you have invested in properties and have capital gains, you may have to read a bit more about taxes on capital gains; just a little bit more time.
Don't go wild on taxes and complicate the matter; for it is not. And when the country is allowing you to earn your income, it is your obligation to pay up taxes due on that income. I know people who fret about paying even 10% on their income. Heck, when the tax laws are so friendly for the long term wealth creation, it is meaningless to try to evade or fight the system.
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