Investment School: 2008-09-28

How to calculate HRA for Tax Exemption?

Most of us pay more tax by neglecting to know about House Rent Allowance(HRA) component in our payslip.

What is HRA?

HRA is house rent allowance offered by employers to all its employees. HRA is exempted from taxable income and hence reduces the tax paid by an employee.

How HRA is calculated?

The HRA calculated by the employer is the minimum of the following three amount.

1. Actual HRA given by the employer as mentioned in the payslip.
2. Acutal rent paid by employee minus(-) 10% of his/her basic salary
3. 50% of basic salary in metro cities(delhi,mumbai,chennai,calcutta) or 40% of basic salary in other cities.

Lets take an example.

Ram lives in a house in bangalore and pays a rent of 7,000. The HRA offered by his employee is 6000/month and his basic salary is 20,000/month. Let us calculate the three amount stated above

1. HRA offered = 6,000
2. Rent - 10% of basic = 7,000 - 10% of 20,000 = 5,000
3. 40% of basic salary = 40% of 20,000 = 8,000

Hence minimum of the three , 5,000 is taken as HRA and 12*5,000 = 60,000 is exempted from tax for the current financial year.

Note : You have to pay monthly rent receipts to your employer and you can not have short routes in stating wrong rents paid by you.

What is Capital Gain tax?

Tax is one area where most of us have always loads n loads of questions. One major tax that is associated with any individual who owns an asset is Capital gains tax.

What is Capital Gains?

When a person sells an asset and makes profit out of it, the profit is called Capital Gains. The tax paid on profit of these asset sale is Capital Gains Tax. The asset may include
mutual funds, stocks, house, land,gold and few other. When a person makes a loss out of his asset sale, it is called Capital Loss.

What are 2 types of Capital Gains?

Depending on how long you hold on to your asset before selling, there are two types of capital gains.

Short Term Capital Gains

If a person sells an asset before 3 years from its purchase and if he makes a profit , it is called short term capital gains tax. For mutual funds and equities, it is 1 year.

Long Term Capital Gains

If a person sells an asset after 3 years from its purchase and makes a profit, it is called as a long term capital gains tax. For mutual funds and shares, it is 1 year.

Short Term Capital Gains Tax:

The short term capital gains is added to your taxable income for the financial year and taxed at your income tax slab rate.

Long Term Capital Gains Tax:

There are two ways for taxing long term gains.

1. 10% of your gains without indexation.
2. 20% of your gains with indexation.

Lets take an example for case 2 (with indexation)

Let's say Mr Ram purchased a house of Rs 2,50,000 (Rs 250,000) on June 20, 1996. He sells it on January 20, 2005, for Rs 4,50,000 (Rs 450,000). Since the house was sold over 36 months after being bought, the capital gain will be long term.

First, you calculate the Cost Inflation Index. These indices are fixed and declared by the Central Government every year (see table below). This is called indexation.

Cost inflation index:

Index of the year it was sold / index of the year it was bought
2004-05 index / 1996-97 index
480/305 = 1.57377

Indexed cost of acquisition

= 250000 x 1.57377
= 3,93,443

Long term capital gain

= Selling price – Indexed cost
= 4,50,000 – 3,93,443
= Rs 56,547

Tax payable will be 20% of Rs 56,547 ie Rs 11,310. (Plus surcharge of 10% if applicable)

Importance of Stop Loss

Sensex at 18 months low and global markets feeling the heat of us economic failure, and most of us have accumulated loss in our portfolio.We need to sit and analyse if we can digest the current loss and if we can digest more loss or should i cut back loss and move to fixed return investments.

This is required because each one of us have a certain level of risk appetite and we should ensure that our investments are bearing a risk which is affordable by us. All of us invest our hard earned income and hence we should have a comfort level with your investments.

Any investment made should have the following attributes associated with it.

1. Time period of investment.
2. Stop Loss.
3. Target Amount.

Lets take a usecase and analyse it. Ram makes an investment of 2 lacs in sensex(sensex taken for easy reference) on Oct 1st 2007.

Time period of investment = 3 years
Stop Loss = 10%
Target Amount = 3 lacs

Current Value of investment = 1.5 lacs

What is stop loss?

Stop loss is usually expressed as a %age of total investment. In this case it is 15%. So when your market value of investment reaches 90%(100-10) of your initial investment, you should book your losses and exit from that investment.In this example, Ram should have booked loss when it was 1.8 lacs (10% 2 lacs = 20,000) and exited his investment.

However he continues to hold his investment and his loss has increased from 20,000 to 50,000 now. There are so many Rams out there in the market who does not have a well defined stop loss planned for their investment and hence accumulate their losses.

How stop loss is useful?

Emotions should never play a part in one's investments. When you invest a certain amount and have your target set, you should exit when your target is achieved. In the same case, you should exit when your stop loss condition is also met.

Stock market is all about emotions but an intelligent investor should never get into that trap.

What is the common mistake committed?

Most of the investors, when experience a loss in their portfolio and if that loss is more than a specified stop loss, expect the market to recover and expect their investments to come back to profit at some point of time. But they never know "when will their investments be back in profit again". They live on hope of recovery.

Instead of living on hope of recovery, an investor should cut his losses and analyse the investment he had made and what are the areas that he can improve upon so that his upcoming investments are made properly.

Capital Protection Vs Hope of Profit

When an investor is in loss, he is expecting the market to recover and go back to highs but at the same time he has already lost his capital and he is bearing the risk of losing more of his capital. Capital protection should be given highest priority over expectation of recovery when an investor is experiencing a loss.

What is super annuation?

As explained in the previous article, employees like you and me , make another hidden savings by means of super annuation. So what is super annuation and what are its benefits?

What is super annuation?
Now a days, corporate have two sections in the compensation package. One of them is Gross Annual Income and the other is Cost To Company(CTC). Super Annuation is a fund maintained by the employer on behalf of all its employees. An employee needs to stay for more than 3 years in an organization to get the full benefit of super annuation fund.
Amount invested in super annuation fund per year by employer for employee = 10% of basic sal.
Duration of employment and super annuation benefits:
IF employee stays in a company <  1 year,  he get no amount from super annuation.
IF employee stays in a company  for 1 -2 years, he gets 50% of amount + interest earned on his super annuation contribution.
IF employee stays in a company for 2-3 years, he gets 75% of amount invested + interes earned on his superannuation contribution.
IF employee stays in a company for > 3 years, he gets full amount invested + interest earned.
When an employee leaves a company to another one, he can get his super annuation fund balance transferred to the new company. The interest earned per year on super annuation fund varies from company to company. Each company can choose from a bunch of group super annuation policies offered by insurance companies to employers.
When an individual stops working, he gets 33% of his super annuation fund in lumpsum and the rest of the amount will be given as monthly payments to the employee.
So this explains the reason for being in a company for a longer period. In today's world, people shift companies very often which is not advisable from career perspective as well as monetary perspective.
In the next article, lets see how gratuity also rewards long term employees.

How to calculate your PF balance?

There are some savings that we make without our knowledge. Sounds surprising? but thats what is the reality. An employee in an organized sector have mandatory savings like PF,Employer Pension Scheme,Superannuation,Gratuity. From our monthly gross salary, we make a significant contribution to all four of these. Lets see how much we are saving each month unknowingly in a provident fund.

Provident Fund

For all employees who work in an organized sector, following is the PF contribution every month.

PF contribution by Employee = 12% of basic salary.

PF contribution by Employer = 12% of basic salary.

Employer Pension Scheme

Out of 12% contribution from employer, 8.33% of the contribution (subject to maximum of 541 rs/month) is invested in employer pension scheme.

Lets take an example and understand this.

Ram's basic salary per month = 15,000

Ram's contribution to PF = 12% of 15,000 = 1,800

Ram's Employer contribution = 12% of 15,000 = 1,800

Employer's contribution to EPS = 8.33% of 15,000 = 1250

This 1250 is higher than the max limit of Rs 541/month and hence

Employer's contribution to EPS = 541

Employer contribution to PF = 1800-541 = 1259

So Total PF contribution to Ram's PF account per month = 1800 + 1259
= 3059

How to calculate your PF balance?

Lets say Ram worked in a firm from April 2007 to March 2008.Let us find out what is his balance as on April 1st 2008.

Interest Rate on PF account = 8.5% (fixed by central govt)

So monthly contribution of 3059 for one year @ 8.5% =~ 40,000 (not exact figure)

So in this way you can calculate your return for 'n' number of years for your PF contribution, provided you know your monthly contribution.

I would insist on the readers to get to know their monthly contribution towards PF from your payslip and also collect your PF account statement every year.

Happy Investing!