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Understanding tax deferment: how this concept improves your investment returns?

This article explains the concept of tax deferment and how it helps you convert income into capital gains that improve returns.

Understanding tax deferment: how this concept improves your investment returns?


Posted on 24 May 2023
Author: Sayan Sircar
5 mins read
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This article explains the concept of tax deferment and how it helps you convert income into capital gains that improve returns.

Understanding tax deferment: how this concept improves your investment returns?

📚 Topics covered:

What is tax deferment?

🤖 Explainer: What is tax deferment?

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.

The above concept should be contrasted with the tax on unrealised gains, as paid by US-based NRIs on their holdings of Indian mutual funds, as explained here: Should US-based NRIs sell off their mutual funds and stocks in India?.

How tax deferment gives higher returns for capital gains?

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Concept Of Tax Deferral

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

Related:
How to calculate taxes from capital gains and combine them with your other income

In the example below, we are investing the same amount of ₹10 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.

🤖 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.

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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.

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This post titled Understanding tax deferment: how this concept improves your investment returns? first appeared on 24 May 2023 at https://arthgyaan.com


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