he prime objective for investing in India is to increase the risk adjusted after-tax return. The key is the AFTER-TAX return. While an investor may think, everyone pays income tax and it is a part of the investment; tax means money out of his pocket that is not coming back. It is very important to understand the effect of tax on return.
If you are an NRI from Dubai, UAE, your marginal income tax rate is 30% and you have invested $100,000 in an NRO bank FD earning 10%, your gross income, tax and net income would be $10,000, $3,000 and $7,000, respectively after 1 year. If you continues this investment for 1 more year, your after tax return for 2 years would be $14,490 ($7,000+$7,000+7% on $7,000).
Had your investments been all tax free, you would have made $21,000 ($10,000+$10,000+$1,000). Your loss due to taxes in 2 years would be $6,510 ($21,000-$14,490), increasing your tax rate to 31% ($6,510/$21,000), even if your marginal tax rate is only 30%.
The compounding effect of tax is always higher than the actual tax rate and is called “TAX DRAG”. In other words, it also means reduction of potential income due to taxes, that could have been saved.
The Tax Drag increases with time and rate of return. If you remain invested in the same FD for long term, your effective tax rate (Tax drag) in 10 years and 20 years would be 39.3% and 49.9% (i.e. you pay about the same tax as your after-tax gain) respectively.
The following table shows the effect of tax drag on your income.
Year (a) |
Value Tax=0 (b) | Value After-Tax (c) | Tax free Gain (d)=(b)-100,000 | After-tax Gain (e)=(c)-100,000 | Gain lost due to Tax (f)=(d)-(e) |
Tax Drag (g)=(f)/(d) |
1 |
110,000 | 107,000 | 10,000 | 7,000 | 3,000 | 30.0% |
2 |
121,000 |
114,490 |
21,000 |
14,490 |
6,510 |
31.0% |
10 |
259,374 |
196,715 | 159,374 | 96,715 | 62,659 |
39.3% |
20 | 672,750 | 386,968 | 572,750 | 286,968 | 285,782 |
49.9% |
If your investment generates 15% return every year, your tax drag in 20 years would increase to 58.60% respectively.
20 |
1,636,654 |
736,623 |
1,536,654 |
636,623 |
900,030 |
58.6% |
As the tax drag is 58.6%, you end up paying more to the exchequer or the government than yourself; the amount you could have saved, had you planned your investments right. If the investments were done in a tax-free manner, your return could have increase by 141% (900,000/636,623).
Recommendation:
- Taxes are very important for your investments. Understand the concept of tax drag and plan your investments accordingly.
- Higher the investment horizon, higher the tax drag.
- Higher the return, higher the tax drag.
- Plan your taxes, DO NOT avoid any taxes. Tax authorities have evolved and are using information technology to collect and analyze the data and also issue notices.
- Transfer the funds from NRO to NRE account as interest on NRE accounts is tax free in India.
Benefit:
Investing wisely after considering the income tax and giving more importance to your AFTER-TAX return, could significantly increase your return – sometimes even 100%+ over a long term.