Money Matters - Part I

Financial Savvy for Young Professionals

Hello and welcome to another insightful edition of "The Saturday Roundup."

This week, we start a series called "Money Matters." It will help young professionals learn about financial concepts. It will also equip them to make better financial decisions early on.

Some of these concepts may have been familiar to me due to my academic background, yet most of this financial advice I only received many years later. I don't see this pattern changing even with the internet expansion.

Even now, I find awareness to some of these concepts rare among young professionals. Though virtues like saving is a core to every Indian household, yet passing down financial knowledge still stands rare. Such knowledge could get further skewed if you are a woman.

So, whether you're just starting your career or have been working for a few years, knowing these ideas can greatly affect your finances.

Let's explore these topics with relatable examples to help you navigate your personal finances better.

Today in Part I of this discussion, we cover:

• Understanding Compound Interest
• The Importance of Emergency Funds
• Basics of Taxes

1. Understanding Compound Interest

What is it?

Compound interest is the interest calculated on both the initial principal and the accumulated interest over the periods. The interest you earn each year, gets invested as your principal for the next year, yielding you higher interest next year.

Below example shows how compounding yields better than simple interest. It shows how time stays a key factor to deriving a better yield.

Example:

Consider two friends, Ravi and Priya. Ravi starts investing ?5,000 per month at the age of 25, while Priya starts investing ?7,000 per month at the age of 35. Despite Priya investing more per month, Ravi will end up with more money by the time they both turn 60, thanks to the power of compounding.

Why it matters:

Compounding impacts all your buying, loaning and investing decisions. The loans you take are compounded. The investments you make are compounded.

Buying a new car for INR 20lakhs a year from now would be better. You saved the time value of that money. It would have earned interest in your bank or the market for that year.

Advice:

• Start Early: Begin investing as soon as possible, even with small amounts. Its called the Time Value of Money. The earlier you start investing, the more time your money has to grow.
• Regular Contributions: Make consistent contributions through Systematic Investment Plans (SIPs) in mutual funds.
• Long-Term Focus: Avoid frequent withdrawals to maximize the benefits of compounding. Staying invested is important.
• Delay Non-Immediate Expenses: For each big expense, weigh if you can delay it vs how urgent it is. Let the money grow while it sits invested for the delay.

2. The Importance of Emergency Funds

What is it?

An emergency fund is a savings buffer that covers unexpected expenses like medical emergencies, car repairs, or sudden job loss.

Example:

• Ankita, a marketing professional, lost her job during the pandemic. Because she had six months' worth of expenses saved in her emergency fund, she could focus on finding a new job without the stress of immediate financial pressure.
• Shrey, a finance professional, suddenly faced a critical illness in his family. The expected expenditure for the cure seemed quite higher than the insurance coverage. The insurance clause also required him to co-pay some part of the insured covered amount upfront and reclaim later. That's when his emergency funds came to his rescue.

Why it matters:

Having an emergency fund prevents you from relying on high-interest debt during tough times, thus safeguarding your financial stability.

Advice :

• Set a Goal: Aim to save at least six months' worth of living expenses.
• Separate Account: Keep your emergency fund in a dedicated savings account or liquid fund.
• Automate Savings: Set up automatic transfers to your emergency fund to build it consistently.
• Keep it liquid: It may not be necessary to keep such funds in cash or in a savings bank account. You could also distribute it across FD or even in blue-chip equity. The main requirement is to ideally have this fund accessible within 2days from day you place the request, called as Trade Date+2days (T+2).

• Restrict its usage: Restrict usage of this fund only for critical requirements. Avoid using it for impulse purchases or regular use. Replenish the fund as soon as possible, if used.

3. Basics of Taxation

What is it?

Understanding how taxes work is key. Various types of taxes apply to you as an individual and there are multiple ways to efficiently use the tax laws for your benefit.

• Direct taxes are paid directly to the Government. Income tax applies on your income, Capital gain on your profits from purchase and sale of your investments. Property tax and stamp duty apply on the purchase of your property.
• Indirect taxes are collected indirectly. GST and VAT apply on your consumption of goods and services. Customs Duty applies on import of goods across borders. Securities Transaction Tax applies on each transaction you do either buying or selling stocks.
• Income tax (including capital gains tax) taxes you on all your sources of income. The remaining taxes are deducted from your post-income tax, that you bring home.

Why it matters:

Taxes make more than 50% of your income (30.9% income tax including education cess, 5%-18% GST, 10%-15% capital gain tax, 5%-20% property tax and so on).

This implies every year you pay more than 50% of your income to the government. While we plan a lot around saving, we usually tend to blindly accept this deduction without learning more about it.

Planning your taxes efficiently could save a significant amount of money that can be redirected towards investments or savings.

Example:

• Raj, a software engineer, maximizes his Section 80C deductions by investing in ELSS (Equity-Linked Savings Scheme) and contributing to his EPF (Employee Provident Fund). Additionally, he claims deductions on his medical insurance premiums under Section 80D, which reduces his taxable liability.
• Using instances like marriage to transfer high-value investments, can help reduce tax liability. Section 56 of Income Tax Act.
• For a family, creating a HUF could be a good way to save some tax.

• Joining bonus is deemed income and income tax applies. However, refund of the joining bonus due to not following the cliff period is not a tax deduction. This is true if the refund occurs in a different FY.
• Vesting of ESOPs is not considered as your income. However, when you exercise your ESOPs, its deemed as your income, and tax needs to be paid on it. Further, listed ESOPs and non-listed ESOPs attract different tax rates.

• Reinvesting capital gains from residential property into another residential property could cut down capital gain tax.
• Selling your poor-performing investments in the same FY to offset your capital gains could help reduce your tax liability.

Advice:

• Educate Yourself: Get into a habit of reading about each new section of tax law that you find out.
• Maximize Deductions: Plan investments to take full advantage of deductions of Income Tax Act - Sections 80C, 80D, 80DD, 80E, 80G, 80GG, 80U. There are deductions on medical insurance premiums, home loan repayments, investments, donations etc.
• Capital Gains Optimization: If you are a salaried individual, your income is taxed upfront without a scope for deduction for expenses. However many clauses do provide an opportunity to reduce capital gains (examples above). Prefer a longer holding period for lower tax rate on Long Term Capital Gains vs Short Term Capital Gains. Section 54 of Income Tax Act.
• Efficiently distribute assets in your family: A common way to reduce tax liability is to distribute assets between trusted members of your family. However be cautious of tax clauses that club such income from assets as your deemed income. Section 64 of Income tax Act.
• Do your Taxes: Owning up small tasks like tax-filing helps you see how your taxes get computed. It also shows you ways to plan it well.

Becoming financially savvy doesn't happen overnight, but with consistent effort and a willingness to learn, we can take control of our personal finances. Start small, stay informed, and make smart financial decisions today to secure a better tomorrow.

In the upcoming edition of the "Money Matters" series, we cover topics like the impact of credit scores, mutual fund investments, and health insurance, readiness for home loan etc.

So stay tuned!

Hope you found these tips useful. If not, do share your feedback on comments below. If you have any interesting ideas and want me to write about it, write to me and feature on my next newsletter!

-Anupama