Thieves who steal your wealth...

If you are person who earns regular income and has some hope of establishing a nest egg for your retirement, you should be careful of two thieves who can steal your wealth away from you.

The two thieves are taxes and inflation.

If you are a salaried employee, you might know the impact of taxes on your income. You may not feel the impact since tax is deducted by your employer before the money reaches your bank. If you are in the 30% tax bracket, over the year you will pay about 30% of your salary as tax, which is like working about 4 months in a year free for the government.

Taxes are one of the main reasons why there is a significant mismatch between salary perceptions between an employee and the company. Company has to pay the salary as per the contract whether it is paying you or to the government. Employees, on the other hand, get much lower pay than they were expecting.

No wonder. A salaried employee in the highest tax bracket is working without pay for almost 4 months in a year.

Also remember, Personal Income Taxes are not the only taxes that we pay. In addition to the Personal Income Taxes, we feed the additional appetite of the government for our money by way of what are known as 'Indirect Taxes'. Every time we purchase a good, we pay sales tax and every time you purchase a service, you end up paying Service Tax. 

If the purchase involves both a good and a service, for example buying a Television and Installation Services, we end up paying both the taxes. 

When it comes to direct taxes, like Personal Income Tax, government offers at least some way of minimizing the burden. Tax laws in most of the countries provide for either deductions from personal income or a few exemptions to the taxable income. We can lower our effective tax by creatively using the deductions and exemptions. 

(Some people say that Personal Income Tax on salary income is a form of double taxation. The company already pays taxes on its earnings. Charging Personal Income Tax on Salaried Employees is like taxing the same income twice, once from the Company and other from the employee)

Left unplanned, taxes can create havoc on your retirement planning. 

Now we come to 'Inflation'. This is a real silent thief. Insidious and unobtrusive are the adjectives that I am looking for to describe Inflation. This thief is totally unknown to most of us. Like rust eating iron, Inflation continuously and consistently eats into our wealth. It is omnipresent like air and is invisible and dangerous like electricity. 

What is inflation? It is defined as the 'Rate at which the general prices are rising and the purchasing power is falling'. Inflation leads to fall in purchasing power, which means that if you are spending 100 rupees today to buy one Kg of Onion (!), tomorrow (one year later) you will get less than a Kg of Onion for 100 rupees. 

Normally Inflation is measured in terms of Whole Sale Price Index, what is known as WPI Inflation. In addition to WPI Inflation, there are six other types of inflation that can hurt the common man. These are:

1. Consumer Price Inflation (CPI) also known as Retail Inflation
2. Food Price Inflation
3. Educational Cost Inflation
4. Medical Cost Inflation
5. Housing Inflation
6. Lifestyle Inflation

Most of the current savings mechanisms available to us do not protect us from Inflation. Many of us invest a lot (most) of our savings in Bank Fixed Deposits. This is the choice of investment for many seniors. When it comes to Bank FD, both these thieves lead a co-ordinated attack on the returns. Interest Income is taxed, so there goes down your return. What is left of the interest and the capital is impacted by inflation. 

Is there any weapon that we can use to attack both these villains? Is there an Investment 'Brahmastra' or an Investment 'Thunderbolt' that can help a common man defeat and destroy these nefarious personalities?

Yes. Fortunately for us, the answer is that such a weapon exists.

It is called Investment in Equities. In most of the countries Long Term Capital Gain is taxed at much lower rates than the return on any other investment mechanisms. In India Long Team Capital Gain is Zero. Over the past several years, Equities have provided significant 'Inflation Adjusted' positive returns to the investor. In Indian context, the value of Sensex in 1979 was 100 while today it is at 25000, a 2500% jump over the last 35 years, which means a return of 17% per year over the last 35 years. If you subtract an average inflation of about 10% over the same period, your effective return (also called the 'Real Return' ) is about 7%. 

By the same standard, the Real Return from an FD paying 10% Interest is negative 3.5 percent, which means that your wealth is depleting. 

Next question is, how do I invest in Equities. The best way to do that is using Systematic Purchase Plans. 

As I explain in this article, you can follow Systematic Equity Plan whereby a specified amount invested in a regular frequency to purchase shares of a few companies. Since the investment takes place through a mandate that you place with your bank, the investment becomes regular and mechanical. This removes the main equity investment killers out there which are Fear and Greed. 

Investing in stocks takes some expertise. If you think that you do not have the knowledge to choose good stocks to invest or to time the purchases, you can opt for investing in Mutual Funds. Mutual Funds are managed by experts who do the investing on your behalf. Here also you can do Systematic Investment through what is known as SIPs (Systematic Investment Plans). In SIP, a specific amount is invested in a product of a mutual fund company to buy the units of a specific fund over regular frequency. 

By following SIP or more demanding SEP route, you are making regular investments in equity. This means that you are using the Investment Brahmastra to slay the two thieves who want to steal your wealth Vis. Taxes and Inflation. 

Remember, In India only two incomes are totally exempt from Tax. Agricultural Income and Income from Capital Gains from investments in Equity. Why not capitalize on this situation?

(PS: In this article, I am only looking at the impact of Taxes on your Wealth. I am not looking into the philosophical argument whether Taxes are good or not. I have my own views on that)

(One could say that investment in Real Estate also provide similar returns. But one is forgetting the regular annual maintenance costs of maintaining your real estate and the annual property taxes that you pay government to maintain the property. Also purchasing and selling real estate involves a lot of transaction costs to the investor. This is the subject of another post)

To learn more about investing in general and investing in equity in particular, you can read my Book Review Series on Reviewing 50 Finance Books. In particular, I will recommend THIS and THIS