7 ways to earn Tax-free Income

Your guide to debt funds: How you can gain from less-known fund category

Indians will go to any length to save tax. They happily write out cheques to buy low-yield traditional insurance policies or take additional medical cover as long as it cuts their tax. But this zeal to dodge the taxman is missing when they invest in debt instruments. Fixed deposits, recurring deposits and small savings schemes get a big chunk of the household savings pie, while tax-efficient debt funds make do with crumbs. More than Rs 4,90,000 crore of household savings are in bank deposits, while debt fund investments by individuals add up to about Rs 18,300 crore.

This minuscule allocation to debt funds is despite the huge tax advantage and other benefits that these schemes offer. While the interest earned on deposits and bonds is added to your income and taxed at the applicable rate, the income from debt funds held for more than one year is treated as long-term capital gain and taxed at a lower rate.

This is a bonanza for anybody with a taxable annual income of over Rs 10 lakh. Instead of paying 30% tax on interest from fixed deposits, he can pay only 10% tax on long-term capital gains from debt funds. The tax could be even lower if he opts for the indexation benefit, which adjusts for inflation during the holding period.

Of the total Rs 18,300 crore invested by individuals in debt schemes, small investors account for only about Rs 2,850 crore. The rest comes from high net worth individuals (HNIs).

Even though debt schemes have always co-existed with equity funds, they haven't caught on with small investors. Debt funds account for barely 5% of their total mutual fund investments.

Tax haven for investors

The lower tax rate on capital gains, for instance, is just one of the benefits of these schemes. A major draw is that you can indefinitely postpone your tax liability by investing in debt funds. The interest income is taxable on an annual basis, irrespective of the time that you actually get it. You need to pay tax on the interest accruing on a cumulative fixed deposit or a recurring deposit even though the instrument has to mature in 5-10 years.

On the other hand, your investments in debt funds will not have a tax implication till you withdraw them. This also makes these funds the best way to invest in your child's name. When you put the money in your minor child's name, the income from the investment is treated as that of the parent who earns more. This clubbing of income is meant to prevent tax leakage, but investments in mutual funds can circumvent this provision. If the funds are redeemed after the child turns 18, the capital gains will be treated as his income, not yours.

There are other ways to earn tax-free income from debt funds. You can set off losses from other assets against the gains from these schemes. Tax rules allow carrying forward of capital losses for up to eight financial years. For instance, if you had booked short-term losses on stocks and equity funds when the markets slumped in December 2011, you can adjust them against the gains from your debt fund investments till 2019-20.

Source: The Economics Times

Get rid of your bad investments now

Several investors believe that money can be made by buying the right investment at the right time. If they select a good investment and time their decisions well, they think it's enough. They never tire of ruing the investing opportunities they've missed. However, the same attention is not paid to the bad investments in their portfolios. In reality, an investor's portfolio suffers more due to the incorrect decisions that are not acknowledged and corrected. Holding bad investments may be worse than not selecting the right ones.

While the entire universe of investments is potentially available for buying, the decision to sell only involves what the investor already has. It is, therefore, pragmatic to focus on holding the best rather than wondering about what we may have missed.

According to behavioural economists, one of the main reasons for our refusal to sell an investment is our aversion to loss. If our investment turns out to be good, we are happy to sell and feel good about the gains. However, booking a loss is painful, so we tend to postpone the regret we feel at having made the wrong decision. We choose to wait out, ignore, or worse, add more to a poorly performing investment, hoping to average out the cost. Therefore, cleaning up a portfolio is a tough task and calls for rational decision-making. Here are three ways to discard the bad apples from your portfolio.

The rate of return of a portfolio is the weighted average of what we hold in it. If some of our money is stuck in bad investments that show a negative growth, or don't work as hard as the others, we are losing out on the overall gains. If the money from a bad investment is released and redeployed, it may end up doing better.

If we are reluctant to make the decision, it may help to begin with a partial liquidation of the investment that is performing poorly and comparing it over a period of time. When we see how the loss could have been arrested and funds redeployed, we may be able to rebalance the portfolio with greater confidence. For example, those who are still holding the JM Basic Fund bought in 2007 in the hope that they will recoup the loss, should liquidate the fund and pick an index fund to see the benefits of selling what is not working.

We also have to give up the urge to come out good even after we know that our investment decision was bad to begin with. Ignorance is not a pardonable error in investing and when time reveals our decision as a bad one, it is better to act than argue. An endowment policy that was bought to save taxes, a Ulip purchased assuming that it is an investment for a fixed period, low-priced stocks picked at market peaks when good stocks seemed expensive, NFOs bought on an erroneous understanding of the product are all bad investment decisions, ab initio. They will not become better with the passage of time.

However painful the decision, we may have to book the losses arising from the purchase of a bad product. The sooner it is done, the better it is for the investor. Many of us think we should recoup something from the investment. If the performance is poor because the market cycle turned down, it may be worthwhile waiting for an upturn. If the market improves and our investment fails to look up, it confirms the bad choice and the need to quit.

Several investors want to know when to sell and ask frequently about profit booking. The crux of good wealth management is in wisely booking the losses and having a strategy for weeding out bad investments. If such investments are recognised for their draining impact on the portfolio and are uprooted ruthlessly, the fruits of investing are bound to be sweeter.

5 Mutual Fund Myths

It is easy, even for an intelligent investor, to be taken in by the hype surrounding a mutual fund scheme. Such misconceptions can impact the investments, which is why they need to be debunked. Here are the five common myths:

1. A fund with a net asset value (NAV) of Rs 10 is cheaper than the one whose NAV is Rs 50: The NAV of a mutual fund represents the market value of all its investments. Any capital appreciation in the fund scheme will depend on the price movement of its underlying securities. Suppose you invest Rs 1,000 each in Fund A (a new scheme with an NAV of Rs 10) and Fund B (an older scheme with an NAV of Rs 50). You will get 100 units of Fund A and 20 units of Fund B. Let's assume that both the schemes invest in just one stock, quoting at Rs 100. If the stock appreciates by 10%, the NAVs of the two will rise by 10%, to Rs 11 and Rs 55, respectively. In both cases, the value of investment rises to Rs 1,100-an identical gain of 10%. Fund B's NAV is higher as it has been around for a longer time and had bought the scrip earlier, which appreciated. Any subsequent rise and fall in the funds' NAVs will depend on how the scrip moves.

2. A balanced fund will always have a 50:50 debt to equity ratio: Balanced funds aim to achieve a balance between equities and debt. But the balance can tip depending on the nature of the fund. The equity-oriented balanced funds usually invest at least 65% in equities and the rest in debt. The others do this in a 40:60 ratio.

3. Large corpus funds generate higher returns:  A fund with a very large corpus is prone to inefficiencies as rising assets become unmanageable after a point. Also, most fund managers are more dexterous managing mid-sized funds. A large fund forces them to broaden their stock universe. This can lead them to include less researched or low-potential stocks in the fund's portfolio or increase the stake in certain stocks, leading to a selection bias. HDFC Equity has a corpus of Rs 2,680 crore, but its three-year annualised return is -1.68%, whereas the best performer for the same period is Reliance Regular Savings Fund, with an annualised return of 7.71% and an AUM of Rs 618 crore. At one-fifth the assets, the Reliance fund has fared far better.

4. Funds that regularly declare dividends are good buys: Fund houses declare dividends when they have distributable surplus. However, there are times when fund managers declare dividends as they do not have adequate investment opportunities. In some circumstances, a fund manager may sell some quality stocks to generate surplus for dividend distribution to attract investors.

5. SIP always scores over lump-sum investing: A systematic investment plan (SIP) is the best way to invest during volatility as it lowers the average per unit cost. This is also termed as rupee cost averaging. However, investing systematically during a bull run results in lower returns. When markets are constantly rising, SIP fails to lower the average cost and so results in lower returns compared with a lumpsum investment.

How to earn higher returns than FDs?

Financial experts are known to repeat the axiom that death and taxes are inevitable in life. But they forget to add one more item to the list: contingency funds. Due to the uncertainties that govern our life, we don’t have an option but to maintain a corpus to meet emergencies. The golden rule, most wizards maintain, is to maintain emergency funds to match at least four months’ expenses.

Such money in most cases is kept in savings accounts or invested in liquid funds or fixed deposits of very short term, say 30-91 days. The idea here is to earn some returns without compromising liquidity.

What are bond funds?:

Short-term bond funds and ultra short-term funds (also known as liquid-plus funds) have emerged as preferred vehicles for investors to ride out rising interest rates. Short-term bond funds are mutual fund schemes that invest in bonds and other fixed-income instruments that have a tenure of around one year. The fund manager builds a diversified portfolio of fixed-income instruments with varying maturities. The portfolio comprises treasury bills, certificate of deposits, commercial papers, securitised debt and advances in the call money market.

The ultra short-term fund focuses on very short-term instruments in the fixed-income space. It invests most of the money in call money and other shortterm instruments, offering good liquidity (for a listing of these funds see table). The Reserve Bank of India (RBI) has increased the repo rate (the rate at which it lends to commercial banks) by 125 basis points in this financial year. This, in turn, pushes up the rate of interest on shortterm borrowings for corporate entities and commercial banks.

What do they do with your money?

These funds invest in financial securities that mature in three months which are currently offering an annualised return of 9%. They also invest in one-year tenure instruments that offer 9.25% returns . Of course, public sector banks have also been hiking interest rates on their fixed deposits. But the returns offered by short-term financial securities are higher than fixed deposits offered by large banks for a similar tenure, which makes the fund route rather attractive.

Let’s take the case of one-year fixed deposit . The interest rate being offered currently by most banks is in the range of 7.5-8 .5% whereas short-term financial securities offer higher returns. Shortterm funds invest in short-term financial securities. So in the days to come it is highly likely that that these funds may give higher returns than those given by fixed deposits.

Why should you invest?:

Also, once an investor invests in a fixed deposit he is locked into it. If the interest rate keeps rising, it will be difficult for him to capture the higher interest rate unless he breaks the current fixed deposit to get into a new fixed deposit. That, of course, has its own issues. But, if the investor invests in ultra short-term funds and short term bonds, he can hope to capture the higher interest rates that may be on offer. These funds invest in different kinds of financial securities which have varying maturity periods.

So, the money coming in from the financial securities that mature can be used to invest in the new financial securities offering a higher rate of interest.

In the recent monetary policy, RBI has left the key rates unaltered. Though the statutory liquidity ratio (SLR) has been reduced to 24% from 25% to accommodate liquidity along with bond buy back, there is no signal from RBI regarding lowering of short-term interest rates. The regulator has not taken any long-term measure to improve liquidity which may bring down the short-term rates.

This is also the season when companies pay advance tax to the government. This means all the idle money that companies have is going to disappear. This, in turn, would mean a further scarcity of money in the market, which would push up interest rates further.

Over and above this, till the end of this financial year — March 31, 2010 — there is a strong line of initial public offerings (IPOs) and follow-on public offerings (FPOs) that are expected to hit the stock market. This will further tighten the money situation, creating more demand than supply, and hence higher interest rates.

Also, to support the increased lending, banks will issue more certificates of deposits on higher interest rates. All these reasons make an even more strong case for investing in short-term and ultra short-term funds.

It makes sense to look at exit loads if any, especially in case of short term bond funds before investing. Funds with low expense ratio spell out better returns.

What about tax?:

An investor looking to invest in these funds with a less than oneyear time-frame in mind should ideally go for the dividend option to ensure better post-tax returns. The dividends declared by liquid-plus and short-term bond funds attract tax at 13.841%. If you opt for the growth option, your gains will be treated as short-term capital gains and taxed according to the income tax bracket you fall into.

So, if you fall in the top tax bracket, you will be taxed at the rate of 30.9%. Mutual funds typically keep declaring dividends on these schemes so as to ensure that investors’ gains are taxed at a lower rate of 13.841%, making the monthly dividend option more attractive for short-term investors.

Also, if you want to invest for a period that exceeds one year, and you happen to choose the growth option, your gains will be taxed at the rate of 10% without indexation or 20% with indexation, which ever is higher. If you invest in a fixed deposit and fall in the top tax bracket, the interest earned will be taxed at 30.9%.

What are the risks?:

But a point to note is that interest rates and prices of financial securities move in opposite directions. So, if interest rates keep going up, the prices of financial securities go down. This is because the newer financial securities offer a higher rate of interest. This, in turn, means that the net asset value of the scheme also goes down, leading to lower returns.

So, it is essential to enter these funds at the right time and stay invested throughout the up-cycle . In case of short-term bond funds, once you get your timing of investment right you should stay invested for at least a year’s time to ride out the investment cycle as well as ensure that your capital gains are taxed at lower tax rates.

Four financial thumb rules you can follow

Here are some time-tested financial thumb rules pertaining to borrowing and investing in fixed deposits

They say when your values are clear to you, making decisions becomes easier. The maxim also works when it comes to making financial decisions. Here are some time-tested financial thumb rules pertaining to borrowing and investing in fixed deposits. However, there are several other thumb rules for various financial decisions.

While borrowing, monthly rest is better than quarterly and quarterly is better than annual.

When you take a loan, the most important parameter to look into is the rate of interest. Then there are fees such as processing and pre-payment charges, loan tenor and the like. Let’s assume that you have an option to borrow from two different lenders and all the parameters are the same. How would you choose then?

The word “rest” is used in the milieu of a reducing balance loan. Rest describes the periodicity at which the principal amount is reduced as you repay the loan. Rests are usually monthly, quarterly and annual.

How it works:A monthly rest takes into account the reduced principal after each equated monthly instalment (EMI) and accordingly applies the interest rate on the reduced principal. If the rest is quarterly, the repaid principal amount is adjusted every quarter and so on.

It’s always best to go for monthly rest, loans with annual rest become expensive. For instance, if you borrow Rs. 5 lakh at 12% for 20 years, the total interest you pay on a monthly rest clause is Rs. 8.21 lakh. You pay Rs. 8.24 lakh on quarterly rest and Rs. 8.38 lakh on annual rest.

Not more than 30-35% of your income.

An average urban family today has two to three loans—such as loans for home, car and consumer durables—going at a given point of time. But while taking loans has become easier, repaying them could become a problem and you may not even realize when you slip in a debt trap.

So ensure your borrowing should never exceed 30-35% of your income. This means that if you earn Rs. 100 per month, your EMIs should not exceed Rs. 30-35 a month.

About 30% of monthly income as EMIs for all debt is ideal. Anything more than that could cause trouble. For instance, if the EMI on your home loan goes up due to rise in interest rates, there is a good chance of you getting trapped. If more than 45% of your income goes to service debt you are already heading into a debt trap.

Remember the ratio 20:4:10 when taking a car loan.

Most people buy a car on loan and this ratio would be useful in making a decision. In this ratio, 20 (or more) stands for down payment, ensuring that you have paid a substantial amount initially, which will decrease the overall cost of your loan.

Then, 4 stands for the tenor. While banks may offer you a car loan for up to seven years, it’s best to stick to a four-year tenor or less. Says Ranjit Dani, a Nagpur-based certified financial planner, “The longer the tenor of the loan, the higher is the total cost of the loan; the sooner you get rid of the loan, the better the deal.” That way not only does the total cost of the car goes down, you also get to own it sooner.

The last figure in the ratio, 10, stands for the percentage of your monthly income you should shell out for your car EMI. In other words, your car EMI should not exceed 10% of your monthly income.

Higher the compounding, more the amount of future value.

When you make an investment, the instrument quotes the nominal rate of interest. But that may not necessarily be the rate of interest which you would actually earn. Your earning depends on the type of compounding applied, so your effective rate is the annual rate of interest that accounts for the effect of compounding. A rate can compound monthly, quarterly, semi-annually or annually.

Let’s assume you invest Rs. 50,000 at 12% for a year. If the instrument compounds the interest on a monthly basis, your Rs. 50,000 will grow to Rs. 56,341.25; if the instrument is compounded quarterly, you will get Rs. 56,275.44; with semi-annual compounding, you will get Rs. 56,180; and with annual compounding, you will get Rs. 56,000. This clearly shows that the shorter the compounding frequency, higher would be the future value of your investment. In monthly compounding, you earn interest on interest compared with annual compounding. Higher the compounding, more is the incremental amount you earn.

Keep in mind that interest of fixed deposits can be compounded quarterly, half-yearly or annually and varies from bank to bank.

Following these general thumb rules will help you make informed decisions.

Small savings committee proposes to restructure agent commission

The report by finance ministry’s committee on small savings recommends either reducing or completely abolishing the commission paid to agents on various small savings schemes

The finance ministry’s committee on small savings chaired by Shyamala Gopinath, deputy governor, RBI, has recommended either reducing or completely abolishing the commission paid in the Standardised Agency System (SAS), Mahila Pradhan Kshetria Bachat Yojana (MPKBY) and Public Provident Fund Agents (PPFA). These recommendations were made in the report “The Committee on Comprehensive Review of National Small Savings Fund (NSSF)”.

The committee recommends that under PPF, the commission should be abolished, as 90% of the transactions are happening through banks and for banks commission is not payable for any other scheme. They feel that 4% commission under MPKBY is very high and is affecting the viability of NSSF.

The committee recognizes that the recurring deposit (RD) scheme requires considerable effort on part of agents in mobilizing monthly deposits. But calling the 4% commission distortionary and expensive, the committee recommends bringing down the commission to 1% in a phased manner in a period of three years with a 1% reduction every year.

In addition, under SAS, the committee recommends that commission of 0.5% should be abolished on Senior Citizen Saving Scheme whereas on other schemes, it should be brought down to 0.5% from 1%.

According to the report the 13th Finance Commission (FC) noted that, “Incentives such as cash awards to officials and other similar measures to promote subscription to small savings instruments either add to the cost of administration or affect normal market linked subscription. Hence, such incentives should be proactively withdrawn by the state government.”

Agreeing with 13th FC, the committee noted that agency charges distorts the investment pattern and increases the effective cost of borrowings for NSSF. Thus, in order to ensure that the state governments do not give any extra incentive to the agents, the committee has recommended that the incentive paid to the state government may be reduced from the incentive payable by the central government to the agents.