Tax deferment refers to a financial strategy or arrangement that allows individuals or businesses to delay the payment of taxes to a later date, typically beyond the current tax year. Rather than paying taxes immediately on income earned or gains realised, tax deferment allows taxpayers to postpone their tax liability and retain the funds for investment or other purposes.
Tax deferment allows you to pay tax on a date in the future, typically at a convenient time, for money coming to you from an asset.
An example of tax deferment is the capital gains tax you pay, as a resident Indian investor, on selling units of a mutual fund in India. Tax is due from the profits of the sale, as capital gains tax, only when you sell the units.
How tax deferment gives higher returns for capital gains?
(click to open in a new tab)
The table above shows that income-generating assets like FD, savings bank accounts, coupons from bonds and rent from properties all share two common characteristics:
the investor does not have control over the cash flow date. For example, the company declaring dividends will follow their stated dividend schedule
tax is due as soon as the income is received. In many cases, TDS may be applicable as well
Both of these points reduce returns when:
the investor can choose the date of incurring capital gains by timing the selling date
the tax is paid at the end of the investment period and not in between
In the example below, we are investing the same amount of âč10 lakhs in an investment that gives 7% investment a year, in cumulative mode, for an investor in the 30% slab.
The investments are an FD where tax is due on an accrual basis. A debt mutual fund, maybe in the liquid fund or target maturity categories, is expected to give returns similar to FDs.
In an FD, you are expected to pay tax every year on the amount of interest received that year. This is called the accrual method of tax calculation. In a mutual fund, tax is paid at the time of sale, and there is no tax to be paid in the middle.
Item
FD with tax on accrual
MF with deffered tax
Initial investment
-10,00,000
-10,00,000
Year 1 tax outflow
-21,000
0
Year 2 tax outflow
-22,470
0
Year 3 tax outflow
-24,043
0
Year 4 tax outflow
-25,726
0
Maturity / Sale date
13,75,025
12,81,786
IRR
4.90%
5.09%
As the IRR numbers show, tax deferment improves returns. In the example above, even though the final amount is lower in the case of the mutual fund, the fact that there are no intermediate cash outflows due to tax improves the absolute return value.
đ€ Explainer: What is time value of money?
The time value of money (TVM) is a fundamental concept in finance that recognises the idea that money available today is worth more than the same amount of money in the future. The principle is based on the premise that money can earn interest or be invested to generate returns over time.
The intermediate tax paid in the case of the FD interest has the opportunity to compound inside the mutual fund, which leads to higher returns.
Did you know that we have a private Facebook group which you can join for free and ask your own questions? Please click the button below to join.
Applying tax deferment to improve returns during retirement
In a future article, we will explain how the concept of tax deferment can be applied to retirement so that the retirement corpus lasts longer.
What's next? You can join the Arthgyaan WhatsApp community
You can stay updated on our latest content and learn about our webinars.
Our community is fully private so that no one, other than the admin, can see your name or number. Also, we will not spam you.
To understand how this article can help you:
If you have a comment or question about this article
The following button will open a form with the link of this page populated for context:
If you liked this article, please leave us a rating
Disclaimer: Content on this site is for educational purpose only and is not financial advice. Nothing on this site should be construed as an offer or recommendation to buy/sell any financial product or service. Please consult a registered investment advisor before making any investments.
This post titled Understanding tax deferment: how this concept improves your investment returns? first appeared on 24 May 2023 at https://arthgyaan.com
Tax
