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Post Tax returns should beat inflation
The old saying `a penny saved is a penny earned' does not apply these days, thanks to inflation, resulting in that penny being worth less over a period of time. Moreover, most individuals confuse savings with investments, not realizing that there is a huge difference between the two. Savings is the amount of income left after expenses. Deploying savings to earn returns is an investment activity. Thus, the very first step is to make the money work for you as hard as you have worked to earn it.
Idle money is savings and money put to work is investments.
There are various types of investments but broadly speaking, they can be categorized into property, fixed income, equity and gold, among others.
The returns of each of these assets would vary based on the risk they carry: Higher the risks, higher the reward. Choosing the most suitable investment instruments for you is a separate topic of discussion.
What is investment?
Investment means putting your money into some avenue so that it will yield some gains. The main facet of an investment is that it should make your hard earned money earn more money for you.
For example, putting money in stocks or equity mutual funds counts as in vestment; buying property is an investment too. The objective of an investment should always be to beat the rate of inflation.
Once you have decided on the investment instrument, you need to understand two critical aspects
(1) The impact of inflation on the returns you earn from it and
(2) the impact of tax on the returns.
Impact of inflation on returns Inflation eats away your savings, bit by bit, and you cannot afford to ignore the corrosive effect that rising prices can have on the value of your assets. It has been rightly said by Milton Friedman that "Inflation is a taxation without legislation."
For instance, Rs 100 earned will be worth just Rs 94 after a year if it is not invested and the inflation rate is 6%. That is why you must always be on the look out for investments whose returns are more than the prevailing inflation rate.
Thus, you will always face the challenge of beating inflation. To fight inflation, the key is to invest in products which gives you a higher rate of return than inflation, and ultimately leave you with a surplus to meet your goals.
Understanding post-tax returns The tax impact is a very widely ignored aspect of investments and one that many a times leaves us com paring apples with oranges.
Let's understand this with the help of an example. Let us assume that an investment in a bank FD earns you 9% interest annually. Also suppose you are in the 30% tax bracket and the inflation rate is 7%. You will observe above that the returns post tax is less than inflation. What this implies is that you have a negative real return.
If you had instead parked your funds in even a fixed maturity plan, the return would have been approximately 8.5% per annum (post tax). However, unfortunately most individuals are not aware of this and would compare the 9% (pre-tax) return with the 8.5% (post tax) return from FMPs and assume that the former is more lucrative.
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