PPF is a much maligned product due to investor ignorance

My post on PPF received quite an good response yesterday, in fact more than 500 visitors on a single day made it the most popular day for my blog. While many have appreciated the article and had nice things to say about it, there were several queries that were raised about it too. I thought it will be a good idea to cover these in a post for the benefit of all readers.

Maximizing PPF contribution is a stretch at the beginning of my career, should I really be attempting it?

  • How much you are able to put in PPF is a function of your income, expenses and other investments.
  • The long term compounding effect of PPF will grow your initial contributions the most.
  • Inculcating a habit of contributing to PPF is a good investment discipline that will be of use to you.
  • Maximizing the initial contributions will ensure that your PPF corpus reaches a healthy stage by the time you may need to withdraw from it for your goals.

I can withdraw money from PPF only after 6 years, what about goals that may be sooner than that?

  • Well, firstly PPF being a long term instrument withdrawal from it is not the preferred option. This is to be used as an option when it is not appropriate to redeem equity due to market conditions etc.
  • For goals that are in the next 2-3 years you need to plan other financial instruments like debt funds etc.
  • However, for an ongoing PPF account short term goals can be planned through PPF quite easily. You can just increase your contribution in an account ( maybe that of your spouse) which is not being maximized, earn tax free returns on it and withdraw the goal amount tax free when your goal arrives. Use this for goals like vacation or car purchase.
  • Finally, even though you can withdraw only after 6 years there is a possibility of taking a loan from it after 3 years. Again, I would not recommend it as it defeats the long term compounding objective but it is available in extreme cases.

When should I start a PPF account and when should I stop it?

  • I thought I had addressed it in my post but let me repeat it here. You need to start a PPF account as early as possible, even if cannot contribute a lot in it.
  • I started my PPF account when I was 29 and I consider that very late. My daughter is going to be 24 soon and she already has opened her PPF account. So has my son who is 21 and is still doing his internship !!
  • You do not need to stop a PPF account ever, just keep extending it for blocks of 5 years. When you need money out of the account simply withdraw the needed amount. You can withdraw a total of 60 % of your maturity balance prior to the extension. So if I have completed 15 years and have 30 lacs in my account, I will be able to withdraw 18 lacs over the next 5 years.
  • Unless you feel you need more money that this for your use, simply continue the account.

I already cover my 80C limits through my PF contributions, should I still try to maximize my PPF?

  • If you are in a happy situation that your PF contribution is more than 1.5 lacs a year, you can surely afford to maximize your PPF contribution too.
  • Remember that PPF and PF have different roles to play in your overall financial portfolio. I believe that PF should be kept strictly for retirement purpose and PPF used more flexibly for goals that come prior to retirement.
  • Maximizing your PPF contribution will really let your compounding work in the most effective manner.

Should I contribute to PPF or look at something like NPS as an option?

  • Again, NPS is a very different product from PPF and one should invest in it for retirement purposes.
  • NPS can be a good option to PF as it allows some exposure to equity for people who earlier did not have that exposure when contributing to PF.
  • Invest in PPF for the right reasons, most of these were covered extensively in the original post.

PPF gives only 7.6 % interest, why not invest in other products like Mutual Funds?

  • Understand that PPF is part of your debt portfolio, so you can only compare it to Debt Mutual funds. You should definitely be investing in Equity MF but that is a different story altogether.
  • Compared to Debt MF PPF has the basic benefit of being an EEE instrument as far as taxation goes.
  • PPF does not have fluctuating returns and this is a very important consideration for compounding to work effectively.
  • It creates a great habit of investing regularly. Even if I wanted to, I do not know how easy it will be to put 1.5 lacs in a Debt MF every year. I find that quite easy to do with PPF.

Why did you close your wife’s PPF account, when you are advising to continue it forever?

  • Well, this shows the reader was paying attention while reading which is great.
  • Normally, I would not advocate closing a PPF account on maturity but there can be situations where it makes sense.
  • In this particular case we needed the money for making the down payment for our Chennai apartment. Availability of this money meant we had to take a loan of 15 lacs, not something closer to 30 lacs.

Can you share the details of your personal experience of using your PPF account?

I have no problems with sharing it but will do so in my next post. In the meantime keep your comments coming.

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PPF investment is a must for every investor

I have been a supporter of PPF for a long time now and it has been a cornerstone of my financial planning since my early days of investing. It is also a topic over which I have had several debates with many of my friends. The commonly held view is that PPF is an old and stodgy product, rates are controlled by government, it is essentially having poor liquidity and is not something that you need if you are having PF.

Let me explain in this post how I have used PPF and why I think you must have it in your portfolio. I will do this by explaining some of the aspects of PPF and drawing upon my own experience in this.

The first thing to understand about PPF is that it is a long term product and needs to be viewed and used as such. The normal term of a PPF account is 15 years and this can be extended indefinitely in terms of 5 year periods. That being the case, you need to open a PPF account as quickly as possible and keep it going for as long as you can. You must also do the same for your spouse at the earliest opportunity. I had opened a PPF account in February 1994 and it is now in its’ 24th year. My wife has had her PPF account mature a few years back and we have opened another one for her 6 years back.

The second important aspect of PPF is the taxation, which is EEE mode and therefore quite unique among all investment options. This essentially means that you get tax benefits on investment, on the interest earned and also on maturity. LIC policies and PF also give you similar benefits but are nowhere near as flexible as PPF. While one can argue that the government policies can change, PPF is the saving option available to the vast number of workers in the unorganized sector and the chances of this happening are really quite slim.

The third important aspect of PPF is that it is a product that demonstrates the compounding principle like no other product does. You can keep investing in PPF over the years and the compounding logic will work its’ magic quietly. The longer you keep your account going, the more you benefit from it. When I look at my own planning, if I keep my investments going in the PPF account for another 10 years, about 50 % of my retirement expenses can be met from this avenue itself.

The fourth important aspect is PPF instills a sense of disciplined investment of a fixed amount every year. Though the amount you can invest is flexible, once you get into the habit of investing the maximum amount at a particular time you will always do it. Human beings are creatures of habit and once it is formed you will tend to follow it diligently. I invest 1.5 lacs every year by the 5th of April and have known many others who do the same.

The fifth important aspect of PPF is the stability that it provides to your portfolio. While there are other instruments that provide far greater returns on your investment, none of these are giving guaranteed steady returns like PPF does. Over a period of time this builds up to a very substantial figure and serves as a hedge for the fluctuations in the other parts of your portfolio. Investing 1.5 lacs regularly in PPF for 35 years will end up as a corpus of 3.28 crores !!

However, while I like PPF for all of the other things, the real importance of it to me lies in the way I can use it in my overall financial planning. There are really 3 definitive uses that I have of PPF in my financial planning and they are as follows:-

  1. In my current state of financial independence it provides me with a buffer that I can use should other things go wrong. For example, I earn a fair amount of dividend income from my stock portfolio. While this is good, there can be years where the dividend is less due to market conditions. In such a case, I can withdraw some amount from my PPF to meet the shortfall. Note that this is tax free.
  2. I have explained several times that the greatest danger of wealth destruction lies in selling equity at the wrong time. Yet many of us are forced to do it in order to meet a goal. Having a PPF account for a long time ensures that I have enough in it to meet any of my goals save retirement. This means I am free from the vagaries of the stock market. If my goal arrives at a time when the markets have crashed, I simply use money from my PPF.
  3. Once I retire I may or may not keep putting the full amount in PPF depending on funds availability. However, I will continue both of our accounts as it gives me tax free interest at a good rate. In this respect, it is similar to the tax free bonds that some of you may have invested in. I will withdraw money from it as needed and in the end it can be a pretty neat sum for my grandchildren.

Let me now suggest an innovative way of using PPF for short term goals. You may have PPF accounts which you are not funding fully today. Let us say you want to take a vacation abroad in 5 years time. The normal way will be to invest in debt funds or RD / FD etc. However, these involve fairly complex transactions in terms of purchase mechanics and taxation. A far simpler way will be to fund your PPF account with the required amount every year. You earn tax free interest and can simply withdraw the money when the goal is at hand.

My recommendation is that anyone should open a PPF account as early as possible, contribute to it as much as they can, keep it going forever and withdraw from it based on their financial plan. It may not be glamorous or exciting but this is one solid investment that you can depend on and will always stand you in good stead.

I will be happy to answer any specific query that readers may have on investing in PPF.

Interested readers may pls follow my blog on email by clicking on the relevant button on the right hand panel. I will shortly be stopping the practice of posting the links in different Facebook groups. Following the blog will ensure you get intimated whenever there is a new post.

Asset allocation is critical for all investors now

One of the main reasons stock market and other bubbles get created is that we all love good times and good stories. It gives us an emotional kick to see that a stock that we hold has gone up by 10 % in a couple of trading sessions and the MF portfolio we hold has been clocking impressive gains over the last few months. In our heart of hearts and also in our rational minds we do know that the party will end, sooner rather than later, but it is far more exciting to believe that it somehow will not.

We all understand asset allocation at a fundamental level so I am not going into details. However, in simple terms for most portfolios of investors, the following need to be kept in mind when we are looking at asset allocation:-

  • Assuming you have 2 main asset classes Debt and Equity, decide on an asset allocation for yourself. 
  • In my view you must have at least 35% in Debt. This is fairly easy once you take your PF account money into consideration.
  • Periodically review to see if the allocation has got skewed by more than 5 %. In such cases sell from the higher asset and buy into the lower one.
  • For example, right now due to the run up in the markets your equity allocation may be 72% and debt 28 %. Sell off some equity and put it into a debt product such as Liquid fund etc. This provides your partial hedge against a market downturn.
  • What to sell? Again, look at stocks or MF which have run up the most and use your judgement as to which looks like the best bet.

What is my take on the current situation? I feel that there is a little more steam left in the markets yet, the Nifty may well reach 11800 levels by end of this month. However, beyond that or even before there is every likelihood of a correction to 11000 levels and below.I do not believe that we will really see a crash in the Indian markets in the near future, unless there is a change of power at the centre.

Based on the above premise take a serious look at your asset allocation this week and next. It is tough to sell something which is doing so well but you are really protecting some gains and limiting your future losses by doing so. Many people may tell you that you should simply hold and that the gains will again come back in the future. However, that is speculative and asset allocation is a way better strategy which is also a proven one.

I am sure you have never done it in the case of your MF portfolio built up through SIP – one more reason why the way SIP is done and administered, leaves a real lot to be desired.

The reality of any bull market is that there will be intermediate cuts – some not so deep and the others fairly deep. At such points you have opportunity to add more to your portfolio in a productive manner, as long as you have cash to do so. Being conscious of asset allocation and having a strategy for the same allows you to do just that.

Nifty at life time highs – should you cash out your large cap MF’s ?

For some time now Nifty is going great guns and is at a  life time high. Whenever such an occurrence takes place , there is a chance of some correction in the immediate future. This is probably the reason why I have got a lot of messages asking me as to whether it will be a good idea to sell the entire MF portfolio, be in cash and again buy the MFs once the markets seem to have finished the correction.

First things first – your MF portfolio will probably have large cap, mid cap, multi cap and small cap funds in it. Note that Nifty is the benchmark index only for large cap funds and therefore, it makes little sense to be thinking of selling the other types of funds that you hold. As you will see the NAV’s of several of these funds are well below what they were in January and the SIP’s you made in those are probably running at a loss for 2017 investments. So the issue really is this – now that Nifty has crossed 11500, is it a good time to sell your large cap funds and make money, maybe invest in a lump sum when the market inevitably goes down at some point?

Is it possible that you will make money in the short run through this approach? The answer to that is “yes”. Is it therefore a good idea? The answer to this is clearly a “no”. in order to understand why this is so, you need to understand how MF works in the first place. The fund manager has a certain amount of money available and he is buying stocks with it. These set of stocks for a particular scheme will keep changing. The fund manager is doing these changes and you pay him for that very reason. Now if the markets are going down the fund manager may selectively sell some stocks and buy others. As such the scheme you sell and the one you buy are fundamentally different. If you are in the scheme as part of your long term goals then it makes absolutely no sense to sell off the schemes when the markets are at highs. For all you know your fund manager is taking the appropriate decisions by selling some stocks at their highs and buying others which still have a lot of value in them. Do not try to second guess a person who is professionally trained and does this for a living. Just because you can play around with spreadsheets and calculators does not make you competent to take such decisions.

Now what if these funds are not part of your long term portfolio? Well, if you are to sell them anyway then you might as well sell when they are at their highest or near it. In that case my recommendation would be to sell NOW. Yes Nifty can still go to 11700 plus this year and maybe even 12000, but those are fraught with uncertainties. You might as well sell off now and wait for a 5 % drop or more to buy funds that you want to be in for the long term. As I said before with the same fund it does not make sense to change but if you are changing your fund you might as well look at a better entry point.

What if your investments are in Regular schemes and you want to shift to Direct schemes? The same logic will hold – sell NOW and buy after a while.

Over the years I have invested in several schemes and have now reduced it to 5 only. The current market gives me a great chance to clean up my portfolio, in terms of the large cap funds which I am presently not investing in. How do I intend to do it? Read the future posts or the earlier ones in the blog to find out.

Compounding of equity returns – the greatest fallacy in financial planning

In several of my blog posts I have written about the frequent wrong usage of Maths to create misconceptions in investing which are not factually true. One such glaring misconception is for investors to feel that there will be compounding returns on equity investments, at least over the long term. This is simply not true and I would have thought that most investors would be able to understand this. However, as I have got quite a few queries and requests for clarification, let me do so here.

To start with let us fundamentally understand what Compounding is. I have used the following definition from Investopedia:-

DEFINITION of ‘Compounding’

The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

Essentially compounding involves some positive return on your asset, irrespective of what the return might be. Due to this the absolute value of your investment will always be increasing. Note here that we are not talking of inflation and Real returns here. For example, if I have a FD of 1 lac Rs and it pays me an interest of 8 % today then at the end of 1 year I will have an amount of 1.08 Lacs. Now if inflation is also at 8 %, my real return ( interest rate – inflation rate) is 0 and I have not really gained anything in terms of my purchasing power through this investment. At the same time, the absolute value of my investment has definitely grown by 8000 Rs in the one year period. This 1.08 lacs becomes my principal amount in the next year and I earn interest on this new amount. So in effect, compounding entails my earning interest not only on the principal amount but also on the interest amount.

The usage of compounding logic works great with debt products where the interest rates are relatively stable. Take an FD as an example again. At 8 % interest rate your money will double in approximately 9 years, at 12 % rate it will double in approximately 6 years and so on. Your money always grows in absolute terms, ignore the real growth for this discussion.

Now let us look at equities and see if this logic can be sustained in the light of our knowledge of it. If you look at stock prices over a period of time, you will see that it is clearly not so. Let me give you some examples from well known companies and their share prices from fairly recent memory:-

  • ITC reached 400 Rs and is now down to 300 odd levels.
  • Tata Motors went to 600 and then declined to levels of 250.
  • Reliance has had negative growth over years, so has Tata Steel.
  • Some company shares like Kingfisher Airlines and Gitanjali Gems have become penny stocks today.

There are also many examples of company shares having done extremely well and generate spectacular returns. My point here is simple – equities can give great growth but the way to understand that is not through the compounding principle. The growth in equity is non-linear and carries serious risk with it. Now at this point, people may tell you that over the long term of 15-20 years the compounding logic will hold true for equities. Sorry, it does not – if you bought the shares of Deccan Aviation at 146 Rs in the IPO , you have lost this money pretty much forever, never mind how long you are going to wait.

When I think about why there is such a great misconception about something really straightforward, I could come up with the following reasoning in my mind:-

  1. Most people invest in equity through Mutual Funds. As a MF scheme maintains a portfolio of stocks, the overall NAV of the scheme would normally increase in a reasonably good market, which we have had in recent years. If you take the mid cap and small cap funds in 2018, you will see the extent of loss that your schemes have suffered.
  2. Of course, the above can change in a prolonged poor market, but not many of today’s investors have had this experience. 2008 through 2010 was such a phase but has been mostly forgotten now. That is why many investors are shocked in 2018 when the NAV’s  of their Mutual fund schemes went south in a big way.
  3. The usage of CAGR term, somehow makes one think that equity investments compound. This, of course, is complete nonsense but I have seen many sensible people believe this. CAGR is an artificial construct to understand annual returns, it in no way says that such returns are stable and not even that they are positive. In fact you can have negative CAGR and negative IRR / XIRR quite easily.

So, if it is clear by now that compounding logic is irrelevant to equities then how do we go about financial planning with equities as an investment asset class? I will answer that in a future post. For now, do understand that you cannot just hope that you will invest in stocks and it will give you an XIRR of 15-20 % because that has been the historical returns in the index. I really wish life were that simple for me and you, but it does not work like that.

Take heart though – we can make great returns from equity, by understanding the correct ways of investing in it.

Interested readers may pls follow my blog on email by clicking on the relevant button on the right hand panel. I will shortly be stopping the practice of posting the links in different Facebook groups. Following the blog will ensure you get intimated whenever there is a new post.

You must file your tax returns – here’s why

For all tax paying people the August 31st now looms as the deadline, by which you need to submit your tax returns for last FY. New tax payers find it quite overwhelming, many people just avoid it through ignorance or laziness and others depend on their CA or Tax consultants to get it done. It is important to understand the need for filing tax returns and also how one can do it in a fairly easy manner.

First things first – why do we need to file a tax return in addition to paying our taxes? The answer is simple too – our tax deductions are automatic in some cases, partial in others and not there at all in some. It is therefore important for the IT authorities to determine whether you have taken all of your income into account and paid relevant taxes for the same. A few examples will make it clear :-

  • For your salary income TDS is deducted as per your tax calculations fully.
  • For your rental income of any property there is no TDS unless rent is more than 50000 per month. Here too the TDS is at 10 %.
  • For your FD interest TDS is charged at 10 %.
  • For your PO MIS interest, no TDS is deducted.
  • For your Savings bank interest, no TDS is deducted.
  • For your Capital gains from asset sales, no TDS is deducted.

As you can see from here if you just depend on TDS and think you have paid all your taxes, you are quite mistaken. Ideally you should be calculating your tax liability based on your overall income, during the year, and pay advance taxes to cover up the additional tax payment required. These advance taxes can be paid any time during the year and for a quarter the cut off date is normally 15th of the last month. So for the second quarter of this FY, the advance tax payment deadline should be 15th September. If you have extra taxes to be paid, based on your first quarter income then make sure that you pay it off by that date. For the last quarter of the FY, the date is 15th March.

However, if you have not done it this way in the last FY then what is your choice now? You need to file your tax returns with accurate information so that your total tax liability for last FY can be determined. If the tax deposited so far is less than this, you will need to pay the balance tax. This is easily done in the income tax website. In case you do not have an account there, create it using your PAN for registration.

What happens if you do not file the tax return? For one there is no real option and you will be fined heavily if you delay filing beyond July 31st. Also anything associated with your PAN can always come under scrutiny and the first thing IT authorities will check is your Tax return form. If you have not filed it, or filed it with inaccurate information then you are going to face a much sterner examination.

So all said and done, you will need to file your tax returns. In case you are not up to doing it yourself use a Tax Return Professional ( TRP ) to help you. You can, of course, go to a CA but they are more expensive and unless you have multiple sources of incomes that need complex book keeping I will not advise it.

There are some posts in the blog where I show you how you can take care of your income tax and learn enough to calculate your taxes and file returns on your own. It is actually quite simple to do once you lose your initial reluctance.

E-Filing tax returns – How to derive your taxable income correctly?

First the good news – due to increased volume of tax payers this year, the deadline for filing IT returns is extended by a month till August 31st. So, if you were one among the many who were late, you can still go ahead and file your returns now. With the penalty for filing delayed returns starting from this year, it makes immense sense do it on time. It is the right thing to do, you have a chance to rectify it if required, your refunds get processed quicker.

It is important to understand that you need to account for ALL income when you are trying to arrive at your taxable income in a Financial year. In fact, some of these incomes may well be exempt from taxes but it still needs to be declared in the form. In the terminology of Income tax, there are 5 heads in which you need to categorise your income. These are as follows:-

  • Salaries
  • House property
  • Profits or gains from Business or Profession
  • Capital gains
  • Other sources

Let us look into these income sources one by one. For most people filing tax returns, salaries are the bulk of their income. This will be your source, if you are employed by a company or business or another individual and get paid for your time. It does not matter whether you work full time or part time, as long as there is an Employee – Employer relationship, the income can be classified as salaries. When you need to give data for your tax filing purpose, note the following :-

  • Your Employer has to give you Form 16 which will record the total salary paid including the monetary value of perks, exemptions allowed for different allowances like HRA and Transportation, Exemptions under 80 C, 80 D etc.
  • The Form 16 also shows the total tax deducted as TDS and the tax liability. This is why some people think that is enough for tax return filing. However, this is not true as you will be having other sources of income in most cases.

Income from House property is relevant if you own one or more house property. You need to remember the following while filling up this schedule:-

  • Even if you are staying at the house, it still needs to be documented in the ITR returns. For self occupied houses the income will be nil.
  • If the property is rented you have to show the actual income from it. Many people think that for a single house there is no need to declare income – this is completely incorrect and you must never get into this.
  • Standard deduction on income from house property is at 30 % and you can also charge for any taxes or other regulatory expenses incurred in the house.
  • Interest can be charged up to a maximum of 2 lacs per house.
  • After all these deductions from rent received during the year the total income from House property will be calculated.
  • If you have a single house and it is not occupied by you and not rented out, then you can take the income as nil.
  • If you have 2 or more properties there will be a deemed income from all other properties except the first one, even if none of them are rented out.

Most salaried people earlier did not have any income from business or profession but it is becoming more commonplace now. There are of course, many others who do not have a salary but have income from business or profession. While looking at income from this head, you need to keep the following in mind:-

  • If your Business turnover is more than 2 crores or your professional income is more than 50 lacs, you will need to maintain a set of Accounting books and these will have to be audited as per laid out procedure.
  • For others the business income can be taken to be 8 % of gross receipts in business and return filed accordingly.
  • For professionals with less than 50 lacs gross receipts, you can charge 50 % expenses and take the rest as income.
  • In case you are showing income on presumptive basis, as in the above 2 cases, you will not be able to charge any other expenses to the business.
  • If the above does not work well for you, there is always the option of maintaining books, getting them audited and filling up the returns in a more complex manner.
  • For example, if your business turnover is 1 crore but your profits have only been 2 lacs, you will have to maintain books and proceed accordingly.
  • For a professional earning 40 lacs but having 30 lacs as business expenses, it will again make sense to maintain books and show only 10 lacs as income.

Capital gains can arise out of the sale of any asset such as Real estate, gold, Equity, Debt etc. The important things to be kept in mind are as follows:-

  • Short term capital gains are added directly to your income, Long term capital gains will get indexation benefits.
  • For equity LTCG requires holding period of 1 year and is taxed at 10% from the Financial year 18-19. So if you sell your shares after holding them for a year now, you do need to pay taxes on your capital gains. For the last year, these gains are exempt from tax, however, you do need to report it.
  • For debt LTCG is applicable after 3 years of holding and indexation benefits are there. The tax on the Capital gain post indexation is 20 %.
  • In order to save on Capital gains you can put the gains in Capital Gain bonds.
  • For real estate, as long as you invest the capital gains to buy something new it will not be taxed.

Other income is literally everything else from dividends, interests, lottery earnings, winnings from horse races etc. Some common mistakes people do are as follows:-

  • Where TDS is not deducted at all, such as in Post Office MIS, you must declare the interest as taxable income.
  • Where 10 % TDS is deducted as in Bank FD, you must again declare the total interest earned. 
  • Even if no TDS is deducted as you have given form 15 G / H to the bank, the interest earned by you must be declared.
  • Interest exempted from taxes such as interest from Tax free Bonds etc need to be shown too at the appropriate locations.
  • Dividends are again tax free in your hands but need to be shown.

I hope with this you will be able to get all your income recognised correctly. After this you will need to look at taxes paid and if any other liability is there still. We will take this up in the next post as this is already too long.