| Running to Stand Still (or, the Impact of Inflation and
Taxes)
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Everyone knows that inflation eats into savings and
increases costs (to understand how inflation can affect your cost of living,
use our Cost of Living Calculator. But what a lot of people grapple with is how
does one insure oneself against inflation? In this article we discuss why it is
important to invest wisely particularly if you do not want to keep running
(working hard) just so that you can stand still (maintain your current standard
of living).
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| Consider the post-tax, real rate of return |
Whenever you consider an investment option, remember to
evaluate the expected rate of return in real terms. In other words, deduct your
expected compound annual rate of inflation for the investment period from the
compound annual rate of return that you expect from your investment.
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For example, say you are considering a bank fixed deposit
that promises you an 11% annual rate of return over the next five years and
your expectation of inflation during this period is 7% (compound annual).
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For this investment, your real compound annual rate of
return is only 4%. If your income from this investment attracts a 30% tax rate,
then your post-tax real rate of return diminishes further to 0.7% only! A
number nowhere near the 11% that you might be using to evaluate this investment
option!! An investment with such characteristics is a classical example of
running to stand still.
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Let’s look at how you could improve your 0.7% return. If you
are willing to take on a slightly higher level of risk, you could invest this
money into an income mutual fund with a dividend investment plan option. Such
an investment is likely to yield around 11% post-tax return (since dividend
income from mutual funds is non-taxable). This would effectively result in a
post-tax, real rate of return of 4%, far higher than the 0.7% that the bank
fixed deposit would earn for you.
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On a 10-year perspective, Rs10,000 invested today in bank
deposits (yielding 0.4% post-tax, real rate of return) would be worth Rs10,722
whereas the same amount invested in an income mutual fund is likely to be 38%
higher at Rs14,802. Presumably, this should compensate you for the slightly
higher risk to which your investment is exposed. (To understand more about the
impact of compounding returns on investments, see our article on the Power of
Compounding).
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The above example highlights that inflation and taxes are
important factors to consider while evaluating investment returns and how a
little more attention to your investment decisions can result in a significant
improvement in your financial health. (To understand the approach and benefits
of financial planning further, read Guide to Financial Planning.)
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