Monday, June 6, 2011

Why Fixed Deposits are not good for your child :

In many households across India, when a child is born, the first financial investment in his name is a PPF account . Such is the draw of the assured 8% tax-free income that parents overlook everything else-the impact of inflation, their own asset allocation , even the rules that govern the government-managed saving scheme. 

According to rules, an individual cannot deposit more than Rs 70,000 a year in his PPF account. This limit does not increase if he opens another account for his minor child. The contribution in the child's account is clubbed with the parent's limit of Rs 70,000 per year. So, if you invest Rs 10,000 in your child's account this year, you can invest only Rs 60,000 in your own. "If the maximum limit remains the same, you are cutting back on your own retirement planning by investing in the child's name," says Pankaj Mathpal, a financial planner. 

It's no different when it comes to fixed deposits. The interest earned on fixed deposits is fully taxable. "If you invest in a child's name, the income earned is clubbed with that of the parent who earns more and is taxed at the applicable rate," says Hiten Shah, senior manager with Deloitte Haskins & Sells. This makes fixed deposits one of the most tax-inefficient investments for your child. If the deposit rate is 9% and the parent falls in the 10% tax bracket, the effective post-tax rate will be 8.1%. In the highest 30% bracket, it will be 6.3%. "The post-tax return from a fixed deposit will not be able to beat inflation," says Lovaii Navlakhi, chief financial planner, International Money Matters. 

This is true. A high inflation rate of 8-9% means you are not making money on your fixed deposits but your wealth is losing its value over time. "Parents do not factor in the effect of inflation on their corpus when they save for their children's needs. We try to convince them but it's very difficult," says financial planner Veer Sardesai. 

This is why it is important to have a share of equities in your portfolio. Monthly income plans from mutual funds are hybrid schemes that invest in a conservative blend of stocks and bonds. Almost 80% of the money is in safety of debt and only a small 20% goes into equities. In the long term, this small portion of equities has proven very rewarding for MIPs. The best performing schemes have given returns that are far higher than those of the PPF and fixed deposits (see table). What's more, there is no limit on how much you can invest in your child's name in an MIP and there is no tax implication till you withdraw the investment. These MIPs can (and should) replace the fixed deposits in your portfolio.


Having said that, let us also make it clear that fixed deposits have their own place in the portfolio. There is a small window of opportunity to earn tax-free returns by investing in the name of your children. The Rs 1,500 a year exemption for a child's income means you can invest up to Rs 15,000 in a bank fixed deposit and earn tax-free income. This can be availed of for a maximum of two children in a family. The high interest rates offered on long-term bank deposits right now (see table) are very rare. If you have two children, it's a golden opportunity to lock in up to Rs 30,000 for 8-10 years at these high rates. 

As we have mentioned earlier, the suitability of the instrument depends on the time available for the goal. Fixed deposits can be useful in the short term. "When your goals are very near, say 1-2 years away, you should start shifting your investments to fixed deposits," says Mathpal. Debt funds are also a tax-efficient substitute for fixed deposits.
Source : ET

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