The other day, I had an animated discussion with a youngster who is in her final stages of completing her masters and is to commence her work life shortly. The discussion primarily focused on sharing my personal financial knowledge and experience with her, which she very grudgingly tried to accept. I could feel that she was not convinced with my various arguments for the simple reason that her zest to live and enjoy her life through parties, vacations and shopping had obfuscated her financial rationale. Her bewilderment at having to lock-in a sizeable amount of her salary to save taxes, naivety about the fact that wealth creation through compounding needs time and incomprehension that she must plan and start saving for her retirement from now on pushed me into penning down this article for the financial betterment of more youngsters like her.
To make the youngsters understand the financial nuances, I have assumed that they start work at age 24 years in the financial year 2018-19. They get a take home salary of ₹ 5 Lakh (approximately ₹ 40,000 per month) along with a performance based variable component of ₹ 1.5 Lakh per annum. Their monthly expense is roughly ₹ 25 to 30,000 that includes their daily necessities, boarding and lodging, and weekend parties. In accordance with these details, I assume that they save and invest the balance money either into high risk diversified equity mutual fund or tax-saving ELSS mutual fund that generate a modest 10% annualized return over a long-term horizon. To exemplify my subsequent arguments and logic, I have used the under mentioned saving options:
Option 1 – the youngster saves ₹ 10,000 per month (₹ 1.2 Lakh annually) for 37 years till his retirement at the age of 60 years.
Option 2 – the youngster saves ₹ 12,500 per month (₹ 1.5 Lakh annually) for 37 years till his retirement at the age of 60 years.
Option 3 – the youngster saves ₹ 15,000 per month (₹ 1.8 Lakh annually) for 37 years till his retirement at the age of 60 years.
In all three options, the Corpus has grown sizeably after investing regularly for 37 years. As per the table and chart below, in options 1, 2 and 3, the total investment was ₹ 44.4, 55.5 and 66.6 Lakh, whereas, the corpus has grown to 4.18, 5.23 and 6.27 Crore respectively.
|Details||Option 1||Option 2||Option 3|
|No of Years||37||37||37|
Planning and Spending: Whenever youngsters set out on their life’s journey, it is important for them to formulate their life’s goals in terms of their career, marriage, and children. Once they have clearly defined this, then they must break down their life’s journey through various stages to formulate their financial goals. These goals will pertain to their own marriage (if the parents are not financially well off), settling down into their post-marriage home to include buying a house and white goods, furniture and other furnishings that go along with it, children education especially higher education, children marriage, and finally their own retirement. These financial goals occur at different stages of life and saving for them is important. Thomas Jefferson had famously remarked, “Never spend your money before you have it.” Saving up to meet these major financial goals will help minimize debt while keeping a budget in line. People simply buy consumer goods on EMI and spend paying it off along with interest. However, if they can delay the purchase and save for it, then will both avoid debt and paying interest.
Save Pennies to Earn Pounds: Warren Buffet had famously remarked, “Do not save what is left after spending, but spend what is left after saving.” A concerted and conscientious effort by an investor to make small sacrifices will lead to small savings, which over the period will accumulate large wealth and make a huge difference to his lifestyle. Table below exemplifies some common places where youngsters can make small savings:
|Cigarette||Beer||Movies & Restaurants|
|Skip||1 cigarette a day||1 beer over a weekend||One movie & dinner in a month|
|Cost||₹ 15 per cigarette||₹ 200 per pint||₹ 1,500 per movie & dinner|
|Annual Saving Invested||₹ 5,475||₹ 10,400||₹ 18,000|
|Rate of Return||10%||10%||10%|
|Corpus after 37 Years||₹ 19.9 Lakh||₹ 37.8 Lakh||₹ 65.3 Lakh|
|Total Wealth Accumulated||₹ 1.23 Crore|
Starting Early: The aptness of 17th Century adage that ‘early bird catches the worm’ in financial management is unrivalled. Nevertheless, our youngsters are careless with their savings and investments during the first 8 to 10 years of their careers. It is only after about 30 or 35 years of age that they feel the need to save and invest for their financial goals. By then, it is too late and they have missed the investment bus that would have taken them to their identified financial goals. To explain the loss that one incurs by starting investments late in life, I have considered that an individual start investing ₹ 10,000 per month from the age of 24, 30, 35 and 40 years. The table and chart below clarify that the percentage growth loss is maximum when one starts investment at the age of 40 and reduces as one starts investing early.
|Start at 24||Start at 30||Start at 35||Start at 40|
|Corpus at 60 years||4,18,16,931||2,54,84,721||1,53,43,703||90,46,929|
POWER OF COMPOUNDING: For wealth creation you need to give time to the money to grow through compounding. Einstein, while describing compound interest as the eighth wonder of the world had said, “He who understands it, earns it. He who doesn’t, pays it.” Financially, compounding is the process in which one reinvests an asset’s earnings, from either capital gains or interest, to generate additional earnings over time and this makes long-term investing rewarding. If one invested ₹ 10,000 per month in SIP then you will notice in the chart below that the power of compounding grows the wealth exponentially only after about 15 years of regular investment. Therefore, it is imperative to give enough time for wealth creation through compounding.
Save Regularly and Incrementally: A common mistake that people make is to stop the systematic investment in between for a few months or years due to psychological reasons attributable to falling markets or other frivolous reasons attributable to domestic compulsions. The losses incurred by stopping SIP midway and restarting later are dependent on the market situation. One must remember that by continuing the SIP in falling markets, the investor tends to gain due to purchase of additional units as the NAV is also low. In fact, prudent investment philosophy suggests that the investor should increase his SIP annually to harvest better returns eventually (refer the table below):
|Normal SIP||Incremental SIP|
|Monthly Investment||₹ 10,000||₹ 10,000 plus annual increment of 5%|
|Assumed Rate of Return||10%||10%|
|Investment Duration||37 years||37 years|
|Amount Invested||₹ 44,40,000||₹ 84,36,000|
|Corpus after 37 Years||₹ 4,67,86,616||₹ 6,71,84,005|
|Growth||₹ 4,25,46,616||₹ 5,87,48,004|
Inflation Reduces Purchasing Power: The youngster must understand that inflation eats into your returns and reduces the purchasing power. Therefore, today’s ₹ 100 will become ₹ 11.34 in 30 years at the inflation rate of 7 percent per annum and will not buy the same things tomorrow. Table below enumerates some examples to highlight inflationary pressure on necessities:
|Price in 1947 in ₹||Price in 1997 in ₹||Current Price in ₹|
|Milk Full Cream (Ltr)||0.12||18||50|
Real Rate of Returns: Connected with inflation is the real rate of return. It is important for an investor to understand this aspect of personal finance. Suppose a bank fixed deposit gives an interest of 7.5 percent on your investment. If the prevalent inflation is 4.5 percent and you are in a taxable bracket where you are liable to pay 2.55 percent tax on the interest earned, then the real rate of return on the investment is a meagre 0.45 percent. Therefore, for longer time horizon it is prudent to invest into equity either directly or through the mutual funds since they have the potential to beat inflation and deliver higher returns over long-term.
Taxation: An important aspect of financial planning is the taxation policy of the government. Simply put, an individual pays taxes on multiple counts. First is the GST on purchase of goods; second is the income tax on his total income; third is the tax (short-term and long-term based on the duration of financial instruments) on the capital gains from investments or real estate sale. Capital gains tax is chargeable only on the capital gains made during the financial year as per various capital gains tax rate including indexation benefit for long-term investments. Whereas, income from interest earned on fixed income financial instruments is taxable as per existing IT slab of the individual for the entire interest earned in the financial year. Moreover, there is no tax deduction at source (TDS) applicable on capital gains but the same is applicable on interest income from financial instruments. These tax rates are subject to change as per government decision from time to time. The reckoners below will help you understand the applicable rates for FY 2019-20.
|INCOME TAXABILITY AND COMMON DEDUCTIONS/EXEMPTIONS|
|Details||Max Tax Relief Amount|
|a||Gross Salary||₹ 8.05 Lakh|
|b||Various instruments under Sec 80(C)||₹ 1.5 Lakh|
|c||Health insurance under Sec 80(D) if self, spouse, and children are less than 60 years and parents are above 60 years||₹ 55,000|
|d||NPS (Additional Relief)||₹ 50,000|
|e||Standard Deduction for salaried employees||₹ 50,000|
|f||Net Taxable Income||₹ 5 Lakh(a-(b+c+d+e))|
|Note: An individual with taxable income up to ₹ 5 lakh will not pay any taxes. However, if the taxable income is above ₹ 5 Lakh then he will pay taxes as per slab rates given below. He can avail additional tax benefit from home loans and charitable donations.|
|INCOME TAX SLABS (including 4 percent cess)|
|Income Slab||Individual < 60 years||Senior Citizen > 60 years but < 80 years||Very Senior Citizen > 80 years|
|Up to ₹ 2.5 Lakh||NIL||NIL||NIL|
|₹ 2.5 to 3 Lakh||5.2%||NIL||NIL|
|₹ 3 to 5 Lakh||5.2%||5.2%||NIL|
|₹ 5 to 10 Lakh||20.8%||20.8%||20.8%|
|Above ₹ 10 Lakh||31.2%||31.2%||31.2%|
|CAPITAL GAINS TAX (excluding surcharge but including 4 percent cess)|
|Tax||Other than Stocks and Equity Schemes||Stocks and Equity MF Schemes|
|Long-Term Capital Gains (LTCG)||20.80% with indexation benefit if investment held for more than 36 months||10.40% on gains above ₹ 1 Lakh if investment held for more than 12 months|
|Short-Term Capital Gains (STCG)||As per individual’s IT slab if investment held for less than 36 months||15.60% if investment held for less than 12 months|
Retirement Goal: Most people do not realize the importance to save for their retirement from the word go and tend to delay this decision for future. All the financial aspects that we have discussed so far come into play while planning for the retirement. An individual must start early, invest regularly and adequately, and allow power of compounding to grow his wealth to avoid impoverishment during his sunset years. The table below will help you to understand the dynamics of retirement planning:
|Current Monthly Expense||₹ 30,000|
|Monthly expense after 37 years at 60 years of age at 7% inflation||₹ 3,66,709|
|Corpus required at 60 years of age to last 25 years of retired life with assumed annual returns of 10 percent and inflation of 7%||₹ 7.32 Crore|
|Monthly SIP required to build corpus of ₹ 7.32 Crore over 37 years at 10% annualized rate of return||₹ 15,580|