Sunday, May 29, 2011

Education Loan

Education loan helps cut tax

Don't dip into your retirement savings to pay for your children's higher studies. Instead, take an education loan because the tax benefits bring down the effective cost of borrowing.

  While everybody wants their child to have a good education, Indian parents are especially intent on achieving this goad. So focused are they that they are willing to scrounge on basic indulgences to save for their kids' college fees. The problem is that in their efforts to fulfill the needs of the child, they sometimes sacrifice more that they should. They dip into their retirement funds to pay for the education. This is a dangerous strategy because it leaves them financially vulnerable to their sunset years.
We all know that the cost of higher education is raising at a fast pace. Unless you foresaw this trend 10-12 years ago and started investing aggressively for this goal, your savings alone might not be enough to fund your child's higher education. Instead of withdrawing from your Provident Fund or PPF, it's better to bridge the gap with an education loan. It is not only tax-efficient, but helps inculcate financial discipline in the child by making him responsible in his early working years.

It may be argued that taking a loan in these times of high interest rates is not a prudent strategy. You will be paying 12-14% on the loan, while your investments earn only 8-8.5%. However, keep in mind that any loan taken to pay for the education of your child is eligible for income tax benefits. Under section 80E, the entire interest paid on the loan is eligible for tax deduction. The savings in tax can drastically bring down the effective cost of the loan.

The higher the taxable income of the individual, the bigger tax benefits. See Table:
Loan Amt: Rs 500000; Interest Rate: 12%; Term: 8 years; EMI: Rs 8,126

Check Education Loan Calculator for more figures

For someone in the highest tax bracket, a loan taken at 12% p.a effectively costs 8.71% a year. This is very cheap considering today's regime of high in today's regime of high interest rates, wherein personal loans are available at 18-20%. Also, unlike a home loan, where the tax deduction for self-occupied houses is limited to Rs 1,50,000 in a year, there is no limit to the tax deduction on an education loan. However, keep in mind that most lenders don't give education loans for more than Rs 10 lakh, so a limit is set by default.

An education loan will also help in making your child financially responsible in his early working years. Education loans usually come with an EMI holiday and the repayment can be deferred for up to 1-2 year till the student has taken a job. In the initial years, when the financial responsibilities are few, young people tend to be extravagant. However, if you shift the burden of repaying the loan to your child, he will be more careful with his money and is less likely to blow it up at a discotheque or on gadgets and gizmos. The loan EMI will act as a deterrent and force him to be frugal in his spending.

Eligibility for tax deduction:
You can avail of income tax deduction for the interest under Section 80E only if the loan has been taken for yourself, spouse or children. The interest paid on loans taken for siblings or other relatives is not eligible for income tax deduction.

Collateral requirements:
If the loan is more than Rs 3-4 lakhs, the lender may insist on a collateral as security. This could be immovable property, National Savings Certificates, Fixed Deposits, bonds and endowment insurance policies. This is a necessary formality and one should not shy away from providing the collateral.

Specified lenders:
If you are seeking tax deduction, the loan should be from a bank or financial institution notified for the purpose. No tax deduction is available if the loan has been taken from a private source or an overseas lender. Some charitable institutions are also included in the approved list.

Courses covered:
Full-time graduate or post-graduate courses in engineering, medicine, management, applied sciences, vocational studies after senior secondary or its equivalent are eligible for education loans. This can be from any school, board or university recognised by the Central or state government.

Interest deductible for eight years:
Unlike a home loan, the interest deduction is available for a maximum of eight years. If you take an education loan in 2011 and start repaying it in 2013, the interest deduction will not be allowed after 2021.

Saturday, May 21, 2011

Loss Aversion

Why you pick loss over gain

It was mid-2007 and mutual fund investments were giving fabulous returns. Enamored by a particular fund, an acquaintance invested nearly 50% of his SIP money in it. It seemed like a good decision as the fund gave returns as high as 150%. Like many others, he didn't think anything would go wrong. But then on 15-Sept,2008 the Lehman Brothers filed for bankruptcy, and stock markets across the world started to fall. When the NAVs of his star fund went into a free fall, performing worse than the others, the acquaintance conducted a desperate check on the various schemes he had invested in. He found the funds full of speculative stocks.

Despite this, he could not get himself to redeem the accumulated fund units and limit his losses. So the losses continued to pile and he continued to hope that he would recover these. He justified these as being paper losses, convincing himself that til he redeemed the units, the paper losses would bot become 'real' losses. In fact, he started buying more units to average down the cost of buying a single unit. A few months later, the fund manager quit the mutual fund and the value of his investment fell abysmally low. It was then he decided to get out of the fund. Why did he wait till the last minute to rid himself of the pilling losses? He has been a victim of 'loss aversion'.

What is loss aversion?
Loss aversion is the tendency to avoid a loss rather than make a gain. This concept is rooted in the Prospect theory, according to which people tend to base their decisions on perceived gains rather than perceived losses because the emotional impact of losses is far greater than that of gains. Extensive research in behavioural economics shows that people experience twice as much pain when they face a loss in comparison to the pleasure they feel with a gain. So the pleasure derived from a rising Sensex is not as deep as the pain one suffers when it drops sharply.
Another reason  people stick with losing propositions is that they find it difficult to admit they took a wrong decision. They keep hoping that they will recoup the losses, and in the process, they end up deepening these. "When you sell a loser, you don't just make a financial loss; you take a psychological loss from admitting you made a mistake. You are punishing yourself when you sell.", says Jason Zweig, a personal finance columnist at
Wall Street Journal, in his book, Your Money and Your Brain. "Once you make an investment, you can't help regarding it as yours. When you buy a becomes a part of you. From that moment forward, the prospect of having to get rid of it becomes a wrenching thought," he adds.
In fact, people don't stop at holding on to a losing investment. They make things worse by investing more in it a bid to average out the cost. In technical terms, this is referred to as the 'sunk cost fallacy' or trying to recover a bad investment by throwing in more money.

Application in financial life
This theory is amply reflected in our day-to-day financial behaviour. People tend to keep their money in safe debt instruments rather than in equity, despite the promise of higher gains in the latter, because the risk, and the implied loss, in equities is enough to keep them away from the high returns. What they don't realise is that the low returns in safe options will not be able to keep pace with inflation, reducing the purchasing power of their funds several down the line.
Loss aversion also makes people remain stuck to stagnant careers instead of spending money on upgrading their skills and looking for a better job. The lure of an improved and a more lucrative career is not enough to make them part with the money for a degree or a part-time course.

How to escape the loss aversion bias
One way of not falling into the loss aversion trap is to keep the big picture in mind or have a long-term view of your investments. So, sit and actually calculate how much the loss in one fund or stock will impact your entire portfolio before you decide to stick with it. If you are dealing in stocks and don't trust your ability to get out of a losing script, resort to stop-loss order. It will force you into a decision and not allow you to become attached to a particular stock.

Another option is to look for ways to turn your losses into gains. Short-term capital losses make on selling shares and equity mutual funds in less than a year's time can be set off against short-term capital gain as well as taxable long-term capital gain. "The easiest way to do that is to remember that selling investments at a loss creates a tax-deductible event"

Sunday, May 15, 2011

Behavioural Accounts

Don't be fooled by the mind

Lets think about these two incidents. You had bought an advance ticket worth Rs 500 to watch a movie. On reaching the multiplex, you realized that the ticket had been lost. Weekend shows are typically expensive and since you didn't want to spend the same amount again, so you gave up the idea of watching the movie and came back home.
In a separate incident, when a friend of your planned to watch a film, he realized he had lost the note he had kept aside to buy the ticket Not agonizing too much over the loss, he took out another Rs 500 note and bought the ticket.
Both the incidents were basically the same. You had lost a Rs 500 ticket and not bought a new one. Your friend had lost Rs 500 and had gone ahead and purchased another ticket. The loss in both the cases was limited to Rs 500. So why did your friend buy another ticket and you didn't ?
This is a situation what economists call "Mental Accounting" or the tendency to categorize different money situations into separate mental accounts.

What are mental accounts ?
The term mental accounting was coined by Richard Thaller, an economist at the University of Chicago. He defines it as "The inclination to categorize and treat money differently, depending on where it comes from, where it is kept and how it is spent."
In the first case, the loss of ticket was attributed to the "ticket loss account", whereas in the latter case, the loss was ascribed to the "money loss account". The human mind tends to add the loss on the "ticket loss account" to the price of a new ticket, that is, Rs 500, and so people in such situations are not reluctant to buy a new ticket. For you, the movie was worth Rs 500, but not worth Rs 1000.
In your friend's case, the mind values the price of a new ticket only at Rs 500, whereas the Rs 500 lost is attributed to the "money lost account". This explains the different reactions to what is essentially the same situation.

Application in daily life
Mental accounting comes into play in various situations in everyday existence, resulting in a monetary loss or an undesired spend. The victim often fails to realize how the mind has tricked him into bearing the loss, content in the belief that he has cut a good deal.
Suppose you plan to buy a costly mobile phone and find one tagged at Rs 15,500 in a retail chain. Just you are ready to flash the credit card and pay for it, a friend calls. He tells you he has bought a similar model for Rs 15,300 from a shop just 3 km away. Will you drive the distance and save Rs 200? Chances are you won't.
Consider another situation. You want to buy a toaster and come across one selling for Rs 1,200. Just as before, you find another gadget selling for Rs 1,000 just 3 km away. Will you rush to save Rs 200 ? Chances are you will. Why does this happen ?  On a fundamental level, we are thinking in percentages. If Rs 200 is expressed as a percentage of Rs 15,500, it seems very low in comparison to Rs 200 expressed as a percentage of Rs 1,200. At the end of the day, the saving is all about Rs 200.

Another area where mental accounting foxes us is when we come across a windfall, say a tax refund or bonus. More often than not, the tendency is to spend the money as soon as possible. People consider it 'found' money without realizing that it's their money coming back to them in case of tax refund or deferred salary in case of bonus. A small amount of money that comes to us unexpectedly gets treated lightly and we're more likely to spend it on frivolous things we don't need. Bigger sums that come to us, say, from an inheritance, tend to get treated more seriously and are more likely to be saved.

This is the reason people continue to earn low interest rates on fixed deposits in the bank, while paying a high rate of interest on their credit card debt or a personal loan, instead of breaking the fixed deposit and repaying the debt. Remember that the interest you earn on your fixed deposit will always be lower than the interest you pay on your credit card debt.

The bottom line
We need to realize that the money we earn for various sources is basically the same and we should be careful not to divide it into mental accounts while spending it. So, if you get a good bonus or tax refund, don't spend it by categorizing it as 'found' money.
Also remember that money is fungible. This is the reason you should not let money lie in a fixed deposit while you are paying your credit card balance. It makes more sense to first pay your debt instead of saving money before falling into the trap of  'mental account' foolishness.

Saturday, May 14, 2011

Global Income - Tax

5 TAX TIPS if you work abroad 

If you have a job overseas or plan to emigrate, here's how to avoid any tax bloopers in India or the country where you choose to live. 

Governments often demand tax on the global incomes of foreign residents living in their country on a long-term basis. This is set to become more commonplace as governments across the globe, strapped for revenue following the economic crisis, are increasingly exchanging information on tax matters. This is a bid to curb evasion and track money kept in low tax jurisdictions. They are also increasing their focus on high net worth individuals as well as heightening surveillance of accounts held in foreign countries to crack down on financing of terrorism.
Countries such as the US, the UK and Australia now require immigrants who become permanent residents or citizens to report their incomes from all global sources and pay tax accordingly. Temporary residents are not required to declare their global incomes in these countries, but they have to ensure that taxes are paid in the home country. India also requires its residents to pay tax on any income earned overseas, if they ordinarily pay tax in India.

Global income includes anything earned abroad, from rental income and dividends to interest and capital gains. If you are emigrating from India, make a list of your assets, the cost of acquisition, earnings from these assets and the tax paid on incomes and capital gains. For instance, if you own a house in India that is rented out, it will have to be reported as global income if you become a permanent resident or citizen of another country, but you may not have to pay tax on it. 
Permanent residents in the US also have to report inheritances and gifts received in India, though there is no tax liability on such gains either in India or the US.
Conversely, if you are only a temporary resident in these nations, you will have to continue paying taxes in India on the income earned here. You will also have to comply with all the reporting requirements under the Indian tax laws, such as filing the annual information report if a property transaction exceeds Rs 30 lakh. You won't need to declare this income in the country where you are residing temporarily.

The residency rules determine if an NRI has to pay tax in a foreign country in India.There is no common rule across the globe. Countries such as the UK and Australia, which follow the common law system, use a residency test to determine whether a person is required to pay tax in that country. India too follows this system. So, if you have spent more than 182 days in a country, such as India, the UK and Singapore, during the financial year, or more that 729 days in the previous seven financial years, you will have to pay income tax in that country. This means that if you emigrate mid-year, you will pay income tax in India as well as file returns at the end of the year. In the US, foreign residents are taxed as American citizens if they have either acquired a green card or clear the substantial presence/residency test. This test is far more stringent than the residency rules that apply in India and the UK. An individual is said to have satisfied it if he stays at least 31 days in a calender year and 183 days in the current and two preceding years.
To avoid confusion about the number of days spend in a country and prevent double taxation, it will be useful to maintain a travel calendar as well as details of entry and exit as stamped on the passport. Tax authorities could check your passport to determine the residency status. Don't try to fool those guys as they already have the complete picture of your residency status in the country before taking you into consideration.

India has signed double tax avoidance treaty (DTAT) with about 70 countries, including the US, the UK, Australia, Japan, Germany and Switzerland. This ensures that NRIs can claim foreign tax credit if taxes have been paid on incomes and gains made in India. If, however, taxes paid in India are lower than that required to be paid in the country where the the NRI is residing, additional tax will have to be paid. Before you claim foreign tax credit, ensure that you have all the relevant documents as proof.

This current residency rules in India will change when the Direct Taxes Code is implemented, most probable from 1 April, 2012. This change will mean that a person will have to pay tax in India if he spends 60 days (previous 182) in the country during a financial year, or 365 days (previous 729) or more in the previous four financial years.