Use this real returns calculator to check how effective a financial instruments is in protecting the purchasing power of a lumpsum from inflation.
The reserve bank of India has announced the issue of inflation linked bonds in which a lumpsum invested for 10 years will receive an interest equal to 1.5% + 'change' in the consumer priced index (CPI).
This change in the CPI is explained quite well here: Inflation Indexed Securities: Buy if at Lower Tax Slabs
Unfortunately, income from these bonds will be taxed as per income slab on maturity. So if you think the buying power of your lump sum will be protected from inflation, think again.
You will need to calculate the real return after taking taxes into account to check if the buying power has been protected from inflation.
What is a real return? A real return is the return from a financial instrument after accounting for inflation and taxes. Most discussions of real return ignore taxes and simply account for inflation.
The post-tax real return is calculated as shown in the picture
If the real return is 1%(-1%) then the purchasing power of the lump sum has enhanced (diminished) by 1% (-1%).
- If the real return is zero, the purchasing power of the lump sum is unchanged. That is inflation and taxes have exactly nullified the return from the financial instrument.
- Intuitively, it is clear that because of the nature of taxation (as per slab), the real post-tax return from these inflation indexed bonds will be quite low.
- The above post-tax return is valid if tax is paid as per slab each financial year.
- If tax is paid as per slab upon maturity, the formula is (thanks to Ronnie Joshua Reuben for pointing out an error)
post-tax-return =[(1+return)^duration x (1-tax)]^(1/duration) -1
Here is a real returns calculator with which you can access the effectiveness of these RBI inflation indexed bonds or any other financial instrument in protecting the purchasing power of a lumpsum from inflation. Both types of post-tax return computation are included.
- The calculator can be used for any financial instrument. Set the base interest rate (1.5% for inflation indexed bonds) to zero for other financial instruments.
- The calculator gives you only estimate. For inflation indexed bonds, the net pre-tax return will be known only on maturity and will be determined by the course of inflation.
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