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Inflation is injurious to your wealth

“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” – Red Queen from the book Alice in Wonderland.

Power of compounding is called the eighth wonder of the world, However not many of  realize that inflation is the Himalayan blunder that we all do without realizing.

Consider that you had Rs. 100 as capital in 2010, today in 2015 as per governments cost inflation index it is worth only Rs. 72. In other words you would have lost Rs.28 worth of purchasing power if you kept the Rs.100 hidden under your pillow.

If you reply, hey, i’m smart i saved the Rs. 100 in an FD for 1 year at 9.5%, Now i have Rs. 109.5 in the bank, you have just about preserved your  Rs. 100 here is how.

FD
Interest 9.50%
Inflation 6.70%
Taxation 30.9%( at highest bracket)
Net of Tax Return 6.56%
Actual Return post inflation and tax -0.14%

 

So, longer you run the FD more you will lose thanks to inflation and taxes.

PPF and other tax saving investments offer some hope as they are tax free and also investment is subj to tax savings, but they accept only upto 1.5 Lac per annum, this limit is not enough for people with higher income and savings.

Which is why the red queen in Alice in wonderland is right, you have to keep running ( by saving in FD) to be at the same place ( ensure your Rs.100 remains the same after inflation and taxes !!).

But, unlike the red queen you don’t have to run twice as fast as to go to someplace ( to get some real returns on your savings) but you have to make your investments do the job for you in two ways.

Debt Mutual Funds are allowed to be indexed for inflation so the net taxation is only 20% that too post inflation, and if funds like Monthly Income Plans which have 25% equity are considered, returns could be better than FD on a 5 year basis and taxes much lower.

This is however not guaranteed hence people stay away from it, people keep away by saving 100% in FDs,  This is not a either or situation, as one can invest a portion of their savings. For retired people without pension, guarantee may be paramount and hence safety of FDs needed. For those who are working and are several years away from retirement, MIPs can be considered.

Equity mutual Funds : Equities over long periods of time are best at beating inflation, and what is more are tax free too ( after 1 year of investments). On a 10 year basis, equities are better positioned to FDs or any other investments. They are risky but that goes down with both time invested as well and can be invested monthly too to avoid the risk.

So, if you would like some real return post inflation and post taxes invest in debt funds, MIPs and equity funds apart from FD, PPF etc.

Here is a post from the paper Mint making the same point : http://www.livemint.com/Money/lxge86upb1bpBHhVD3hWDO/How-tax-and-inflation-bites-reduce-the-FD-pie.html

Disclaimer : Tax rates and inflation vary from time to time, Returns from mutual fund are subject to market risks.

 

 

 

 

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