You're the kind who likes to celebrate his Sundays on Saturday nights. While you were chilling out at the local pub last weekend, you couldn't help noticing that flamboyant pinstriped suit splurging on champagne and cocktails to impress his girlfriends.
And once the party got over, didn't it burn you up to see him escort his pretty little pals home in a new set of wheels? It was his day -- he'd just got a big fat bonus.
That's how most of Nextgen usually treats large one-offs -- ESOPs, bonuses, legacies, lottery winnings, et al. Blowing it all up gave our friend a feeling of unbridled power that would have lasted a trifle longer than the hangover the next day. After that, it would have been back to square one for him, be sure of that.
And if he continues with such impulsive behaviour whenever he gets big money, he'll end up like the proverbial grasshopper.
So if lady luck smiles at you, don't fritter away her largesse like Lord Pinstripes did last week. Instead, draw up an investment plan that will help you meet the entire range of personal financial goals you'll want to achieve at various stages of life. Here's how you can do this.
Initial plan
Bonus: Chances are that you will have a fix on how much you're going to get -- and when. Conceive an initial plan under which you can park the lump sum in safe and liquid short-term instruments. Sell them when you need the money to meet your personal financial goals. Your best options for the short term (6 months or so), are a bank fixed deposit that offers you a return of 6.5-7 per cent, or a liquid or floating rate mutual fund offering about 5.5 per cent. If you are in the highest tax bracket (30 per cent), liquid funds are suitable as they offer post-tax returns of 4.7 per cent (after dividend distribution tax at 14.03 per cent). An FD, on the other hand, yields 4.5 per cent, as the interest earned is taxed at 30 per cent. Besides, there are exit penalties for premature withdrawals, unlike liquid funds, which can be freely withdrawn.
You won't earn much during this period, but then, you won't lose a dime either.
ESOPs: A booming market has made employees' stock options (ESOPs) popular. But since they come with a lock-in, you can't sell them in a hurry. After the lock-in, however, you may want to sell if you think you're making a killing. Make sure you study the prospects of your company before taking a decision. Says Ranjeet Mudholkar, CEO, Financial Planning Standards Board India (FPSB): "Consider these as something you own -- like an heirloom, for instance -- not as an investment."
Capital gains: Gains arising from the sale of capital assets like a house are usually large and require special attention. These gains are exempt from tax if invested within six months in Section 54EC instruments -- bonds issued by the National Highway Authority of India (NHAI) and the Rural Electrification Corporation (REC). Don't rush. Use the six months to gauge your tax liability and the opportunity cost of investing elsewhere.
Lifelong goals
Your core objective is to see your money grow so you can use it to finance developments that take place at various stages of your life -- your wedding, your children's education, their wedding, your retirement and so on. So let's take a look at some situations you might encounter.
Immediate liquidity: If you need cash today for household expenses or a down-payment for a house or car, liquid or floating rate funds are ideal investment avenues. They can be encashed easily and bear little market risk.
Medium term (3-5 years): If you're getting married or are saving for your children's education, financial planner Gaurav Mashruwala recommends investing in debt instruments like FDs, five-year RBI bonds or short-term debt funds. These instruments yield returns in the range of 6 to 6.5 per cent. Your money won't grow big time, but will be enough to finance these goals. At this stage, protecting your wealth is more important. Here's how you can do it.
Begin with a three-month contingency reserve to meet household expenses and emergencies. Now is the time to insure your house, life and health -- the younger you are the lower your premium. If you already have life cover, you could invest up to 100 per cent of your initial premium as a top-up. The costs are 1-2 per cent of the additional premium amount paid and you can invest in a fund of your choice. But your annual premium should not exceed 20 per cent of the sum assured if you want tax-free withdrawals under Section 10(10D) of the Income Tax Act.
You could also go for a single premium insurance plan, which enjoys relief u/s 80C and offers the flexibility of switching within various fund options. Besides, the gains are not taxable. But there's a cost. For instance, ICICI Prudential Life Insurance offers a plan under which the sum assured is 1.25 to 5 times the premium. The initial costs range from 0-6 per cent.
"The advantage a single premium offers is that it takes care of your investment as well as risk cover, by investing a lump sum," argues Sujit Ganguli, head, marketing, ICICI Prudential Life. If you actively manage your investment over a long term within the insurance ambit, benefits like free switches (four in a year, above which there is a cost of Rs 100 per switch), no entry and exit loads, and zero tax liability on gains will ensure better returns, he adds.
Loan management: We belong to a new generation where loans are not taboo. In fact, they can be great financial planning tools, and a large chunk of the middle class usually leverages and invests simultaneously. For instance, you take a loan to buy a house, but invest some of your own money in bonds or equities, even though you could use it to buy the house outright. "But a loan is a liability. Get rid of it as soon as you can, even if it entails a prepayment penalty," advises Mashruwala.
The decision on what to get rid of depends on the interest rate of each loan you have taken, the residual term, tax benefits, etc. Retire plastic debt and personal loans first -- they are more expensive and offer no tax relief. Home loans could be retained for tax benefits -- the net interest on a home loan (if you're in the highest tax bracket) works out to only 5.95 per cent. Invest your windfall in higher interest-bearing instruments and take advantage of the net difference. But if the loan gives you sleepless nights, then repay.
Medium to long term (10-15 years): If you're building a corpus for retirement or for the next generation, invest in a combination of income and growth securities. You have enough time to see these investments grow and ride through volatilities.
If you're conservative look at PPF, a 15-year product that permits partial withdrawal after six years and offers 8 per cent tax-free interest. Then there's NSC, a 6-year product offering an interest rate of 8 per cent and a bonus of 10 per cent on maturity. The interest is taxable, though.
"Invest your lump sum in equities if you want to make your money work for you in the long term," says Mashruwala. The Sensex has delivered an average return of 19 per cent over the past 15 years. The return from PPF, on the other hand, has fallen from 12 per cent to 8 per cent.
But equities come with higher risks. So if you are not comfortable investing in them directly, go for a systematic investment plan (SIP) in an equity fund. Under an SIP you can invest a uniform amount each month to acquire units at various price points. The mechanism allows you to use rupee cost averaging to help you ride through downtrends in the market.
If you already have a large sum, go for a systematic transfer plan (STP), which works like an SIP. Invest the amount you wish to allocate to equities in a liquid fund; every month a fixed amount (minimum: Rs 1,000) can be transferred to the equity scheme. Remember that you can transfer only between schemes belonging to the same fund house and may have to bear an entry load of 1 per cent and/or an exit load if you withdraw within 24 months.
Taxation
You may need some money to pay tax on your windfall. If it's a bonus, the amount is taxed as part of your salary, at the slab rate applicable to you. Long-term capital gains arising from the sale of property are taxed at 22 per cent if you don't invest them in Section 54EC bonds. Calculate your liability and put that sum aside in a liquid fund to meet this obligation when the tax becomes due.
A piece of advice: Don't obsess about saving tax. Your main objective is to see your money grow. Although investments in Section 54EC bonds will keep the taxman away from your capital gains for now, in the longer run you'll end up losing out on the returns you can get from better avenues (See below: Where to invest your long-term capital gains)
The interest earned on Section 54EC bonds is only 5.65 per cent. Since it is taxable, the net return to you is only 3.96 per cent.
Besides, these bonds offer no liquidity for three years. If you can take some risk, pay the tax and invest the rest of the money in hybrid or equity instruments. You could gain a lot more. If you are conservative, go for bond funds that can yield 4.21 per cent net.
Section 80C investments should be incidental to the financial planning process -- buy insurance or take a home loan only if you need them. Depending on your affinity for risk you could invest some money in an equity-linked saving scheme, which also enjoys relief u/s 80C, or in a standard equity fund that doesn't. Base your decision on the post-tax compounded returns each avenue offers over the long term.
Bottomline: Don't banish fun completely. You've worked for that windfall and owe yourself some indulgence. Once you've invested the lion's share, go right ahead and celebrate your good fortune with your friends over a couple, or more, pitchers of beer and steaming hot spring rolls.
A capital experience
Aparna Narayanan, 30, is an MBA from the UK who works with T- Mobile, London. Earlier, she spent seven years at Bharti Televentures, where she received an ESOP and a performance-linked bonus of 25 per cent of her annual salary. Here's what she did with her windfall.
ESOPs: Narayanan still holds her ESOPs as she feels her company is doing well and the value of her shares might increase. She says she'll sell only if she needs the money badly.
Bonus: For the first two or three years, Narayanan splurged. "I was at an age when luxurious spending calls out to you," she says.
But she began investing in equities and fixed deposits later. Almost 60 per cent of her bonus was usually invested, with more than half going to equities. She received guidance from her family, friends and broker. Although her friends invested in property, she thought real estate was not for her -- she already had a house and didn't need another one.
Result: She realised the importance of investing when she decided to get her MBA from a university in the UK. Her past savings helped finance up to 60 per cent of her total cost.
Today, if she were to receive a bonus, she'd spend 25 per cent on herself and invest 75 per cent equally between equities and debt.
Where You Can Invest Your Windfall Gains
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PPF offers the best possible yield-pre-tax and post-tax-in the 'assured returns' domain. But you can only invest up to Rs 70,000 in a year. Besides, both NSC and PPF don't offer liquidity. Higher up in the risk ladder, balanced funds and equity-oriented funds can offer returns in excess of 10 per cent and are excellent tools for beating inflation. Invest your windfall gain in a mix of the instruments given below, allocating each according to your risk-profile. | |||
|
Instrument |
Expected/typical return |
Lock-in | |
|
Pre-tax |
Post-tax |
| |
|
Liquid funds/Floaters |
5.5 |
4.70a |
Nil |
|
Short/medium-term bond funds |
6 |
5.40b |
Nil |
|
Bank fixed deposits |
6.5-7.0 |
4.55-4.90c |
Tenure |
|
NSC |
8 |
5.60c |
6 years |
|
PPF |
8 |
8 |
15 yrs1 |
|
Balanced funds |
11 |
11 |
Nil |
|
Equity-oriented funds |
15 |
15 |
Nil |
|
aLess than 1 yr, after dividend distribution tax @ 14.03% bAfter capital gains tax @ 10% | |||
Where to Invest Your Long-term Capital Gains
|
54EC bonds are great for avoiding immediate tax on your long-term capital gain. But if you just focus on saving tax today, it could cost you in the long run-even after claiming indexation benefits. We say: if you want your money to grow, look at other asset classesÑyour choice should depend on risk-aversion and tenure. In the long run equities should still perform best. | |||||
|
|
54EC bonds |
Bank deposits |
Bond funds1 |
balanced funds2 |
Equity |
|
Capital gain (Rs) |
100,000 |
100,000 |
100,000 |
100,000 |
100,000 |
|
LTCG3 tax (%) |
- |
22 |
22 |
22 |
22 |
|
Investible amount (Rs) |
100,000 |
78,000 |
78,000 |
78,000 |
78,000 |
|
Pre-tax return (%) |
5.65 |
7 |
6 |
11 |
15 |
|
Tax (%) |
30 |
30 |
10 |
- |
- |
|
Value after 3 yrs |
112,548 |
90,287 |
91,409 |
106,675 |
118,628 |
|
(post-tax) (Rs) |
|
|
|
| |
|
Compounded return4 (%) (post-tax) |
4.02 |
-3.35 |
-2.95 |
2.18 |
5.86 |
|
Tenure of investment: 3 years 1Short term maturities - since interest rates are expected to be volatile, revisit investments after 1 year 2Equity-oriented 3LT capital gains tax on sale of asset 4Compounded returns calculated on the principal amount (Rs 1 lakh) | |||||