Tuesday, December 25, 2007

Discounts, tax deductions can ruin your finances

Marketers study a lot of human psychology. Using this knowledge, they try to lure the consumer to buy their products. The classic examples are a discount sale or free gift scheme. We tend to view the words like “discount”, “free”, and “gift” as if these are the once in a lifetime opportunities. In the process, we end up buying the stuff that we may not need or may buy more that we actually need. Many of us have observed that often we go to a mall to purchase good worth Rs. X and come back with a bill of five or ten times of Rs. X and still feel happy about it, just because we purchased a lot of stuff at a discount. This also looks to be a great approach when we calculate the discount that we got either in terms of rupees or in terms of discount as a percentage of the total price. What we actually did in this case? We just purchased things we might buy in future, or worse, we bought things that may not be necessary. It is a good idea to look for discounts and gifts, but also important to consider the costs attached and our own needs.

Exactly the same approach is also required when it comes to one’s personal finances. Sometimes the words that lure us to take certain decisions may need to be passed through various filters. A careful assessment of our needs with respect to the offerings (be it free gifts or tax deductions or discounts) is key to taking any personal finance decisions.

Tax deductions or tax rebates work as a major incentive when we take some of our investment or loan decisions. One often wonders whether insurance is a risk management tool or a tax saving instrument. One has come across many friends, relatives and others who are either paying high premium for the cover they got or getting very low cover for the premium they are paying. Incidentally, I was also prey to this long back and I still have certain insurance policies, which are costly in nature. However, understanding of the subject later in life has helped me stay away from repeating the mistake. A proper analysis of one’s needs must precede the decision to buy either an investment or an insurance policy. (An investment / insurance advisor can help the investors to do the needs analysis. Such an analysis would come out with different plans for different investors since the needs of all would be different) After going through such an analysis and deciding on the broader options, one may start looking at better offers among similar products.

Let us take an example of two individuals to elaborate the above point. As per the current provisions of Section 80C of the Income Tax Act, 1961, tax benefit is available to the extent of Rs. 1 lac in a financial year per tax payer provided the money has been invested in certain avenues, e.g. PF, PPF, Equity Linked Savings Schemes; or spent in certain ways e.g., school education fees of children, repayment of housing loan, etc.; or used to buy insurance policy. PF or provident fund deduction happens from the salary that an employee draws. We have two investors, one earning much more than the other. Assume that the PF deduction for the first investor (earning less) is to the extent of Rs. 3,000 per month or Rs. 36,000 per year. Also assume that he pays Rs. 9,000 per year towards school fees for his two children. Thus the total tax benefit available to this person is Rs. 45,000. The other investor has PF deduction of Rs. 8,000 per month or Rs. 96,000 per month and has no kids. If someone was trying to plan the amount of insurance required fro both these investors, considering the limit under Section 80C of the Income Tax Act, the investor with higher income needs to pay premium of only Rs. 4,000 per year whereas the other investor needs to pay premium of Rs. 55,000 per year. This argument is exactly against the basic premise of life insurance, which typically is a replacement of the income generating capacity of the individual. The income of both these individuals can be assumed to be in the same ratio as their PF deductions. Let us also assume that both the individuals are of the same age and health conditions. If for the first individual (low income) insurance cover of Rs. 3 lacs is required, the individual two may need insurance of Rs. 8 lacs. The premium for both would accordingly vary, i.e., the first will have to pay much lower premium than the second. Although it is so basic, I did not know about such a thing when I purchased my first policy and the insurance premium was determined keeping the then Section 88 tax benefit limit in mind.

Another area to consider is the option to buy stocks at margin or participating in stock markets through derivatives route. Warren Buffett considers derivatives to be equivalent of dynamite for the investors. While dynamite was invented for noble (pun intended) purposes, it has found wider usage for destructive purposes. Same is the case with derivatives in financial markets. The invention was to offer hedge to someone against the uncertainties in future, whereas majority of the applications are other than hedging. One day, someone approached me with a mouth-watering offer. I could get huge upside if the stock markets go up by paying a small margin, whereas the risk involved was only to the extent of the margin paid. The margin, I was told, was only 10% of the participation amount. In other words, I could buy stocks worth Rs. 100 by paying only Rs. 10. If the stocks went up by Rs. 10, that would be my profit, which is 100% on my investment. But my risk was limited only the margin, i.e. Rs. 10. Such “too good to be true” offers are just that, most of the time, “too good to be true”. If only one asks pertinent questions, the picture becomes clear. In this example, while there is a potential to earn many more than the actual appreciation in the stock markets, the risk also was of losing upto the entire capital invested – although it is called margin, it could be the entire capital invested for the purpose of such an investment.

The idea here is not to dismiss any option or strategy as useless, but to offer a different perspective so that before taking any decision, we consider the relevant points and are in a better position to take an informed decision. As we had mentioned in one of the earlier articles, questions are the best shield in the hands of an investor. Although, discounts and tax implications are very important for a person taking a decision on investments, loans or insurance; the starting point of a financial decision should be the need of the individual and not a tax deduction or a discount.

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