Taxation-A Money eater, can be turned into wealth creator!
Background
Investing an Art or Science, I belief Investing is both, an art, to the extent you should learn to overcome from fears, control your emotions, have patience, control greed etc, and science to the extent you should do research, analyze various data/assets class, knowing various rules and principles of the investments and application thereof. Taxation is one of the most important principles which is always kept in mind while investing, by every successful investor, and the same has been used by them to maximize their wealth. In this article, I have tried to analyze and explain this important concept for us.
Taxation- Naam hi kafi hai, khauf paida karne k liye. We all feel disheartened while paying the tax on our income and feel that a good amount of our income is snatched by the government even before the receipt of the same by us, be it salary income or interest incomes on our term deposits by way of TDS. We all feel, isn’t there a way to reduce the taxes? Yes, there are numerous ways to do that, rich people know those principles very well and apply them to create their wealth.
Robert Kiyosaki in his best selling book “Rich Dad Poor Dad” had explained the importance of principle Axe Your Taxes with very beautiful and relevant examples and how Rich People do the same.
Term Deposits Meaning, Safety, and Taxability:
Meaning and safety of Term Deposits: Term Deposits/FDRs are the unsecured deposits given by an investor to the banks for a fixed maturity of time for earning the interest income thereon.
Taxability: In accordance with the provisions of section 56 of the Income Tax Act, 1961, interest income arising/accruing during the year on the amount of Fixed Deposits made as investments is taxable under the head Income from Other sources in the hands of the investor, as soon as it accrues, in the hands of the investor. Every individual has to pay tax thereon every year.
Debt Mutual Funds Meaning, Safety, and Taxability:
Meaning and safety of Debt Mutual Funds: Mutual fund units are units of an investment pool wherein many small investors give money to the mutual fund managers who on behalf of the investor invests money in various debt instruments which are secured against the underlying assets of the Company (a secured debt). Every company has to obtain rating from rating agencies against the debt of the Company, AAA rating of the debt instruments state sound financial stability of the Company issuing such instruments.
Taxability: Mutual Fund units when purchased under the growth option fall under the definition of Capital Assets as defined under Section 2(14) of the Income Tax Act, 1961, if are held as investments, hence, the capital gain provisions get applied on the taxability of mutual funds units. Section 45 governing provisions of the capital gain state that capital gain on transfer of capital assets shall be taxable in the year in which capital asset is transferred.
Comparison in Taxability of Both
Read the above Two Paras Once again, Read, Okay. Did you notice one difference? Interest income arising/accruing on Term Deposits was taxable each year under the head income from other sources on accrual basis, however, capital gain income is taxable only when you have transferred (sold out) the capital assets, resulting in deferment of payment of taxes, allowing you to use that money for further income generation.
Section 48 of the Income Tax Act, Method of Computation of Capital gain gives an additional and very important advantage to the Capital assets which can’t be ignored by any investor i.e Cost Inflation Index (CII), in simple words, a partial compensation towards rising inflation. When an investor transfers debt mutual fund units after a period of 3 years from the date of acquisition it is classified as a long term asset as per Section 2(42A) of the Income Tax Act, thus, enabling the investor to reap out the benefit of CII.
Intelligent Investing turns Taxation into Wealth Creator
Let’s understand how Income Tax creates wealth for an Investor, by the example of A traditional Investor and A smart Investor.
Assumptions while comparing the data for ease of understanding are as under:
1. Both investors have same money Rs. 5 Lacs.
2. Both get same return on capital 6%.
3. Same tax slab rate 31.2%.
4. CII for the future has been forecasted based on the average of past 10 years CII.
| TRADITIONAL INVESTOR -INVESTS IN TERM DEPOSITS | |||||||
| Opening Amount | Interest for the Year @6% | Tax @31.20% | Cumul-ative tax paid | Incre-mental wealth for the year | Cumu-lative Increm-ental wealth at the end of the year | Wealth at the end of the year | |
| Year 1 | 5,00,000 | 30,000 | 9,360 | 9,360 | 20,640 | 20,640 | 5,20,640 |
| Year 2 | 5,20,640 | 31,238 | 9,746 | 19,106 | 21,492 | 42,132 | 5,42,132 |
| Year 3 | 5,42,132 | 32,528 | 10,149 | 29,255 | 22,379 | 64,511 | 5,64,511 |
| Year 5 | 5,87,814 | 35,269 | 11,004 | 50,827 | 24,265 | 1,12,079 | 6,12,079 |
| Year 10 | 7,19,578 | 43,175 | 13,470 | 1,13,046 | 29,704 | 2,49,282 | 7,49,282 |
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| SMART INVESTOR- INVESTS IN DEBT FUND | ||||||||
| Opening Amount | Capital appre-ciation for the Year @6% | Proje-cted Index-ation | Short term capital gain upto 3 years there-after long term capital gain | Tax rate @31.20% for initial 2 years there-after 20.8% with index-ation | Cumu-lative tax paid | Cumu-lative Incre-mental wealth at the end of the year | Wealth at the end of the year if amount not withd-rawn | |
| Year 1 | 5,00,000 | 30,000 | 301 | 30,000 | 9,360 | 9,360 | 20,640 | 5,30,000 |
| Year 2 | 5,30,000 | 31,800 | 318 | 61,800 | 19,282 | 9,282 | 42,518 | 5,61,800 |
| Year 3 | 5,61,800 | 33,708 | 336 | 37,368 | 7,773 | 7,773 | 87,735 | 5,95,508 |
| Year 5 | 6,31,238 | 37,874 | 375 | 46,189 | 9,607 | 9,607 | 1,59,505 | 6,69,113 |
| Year 10 | 8,44,739 | 50,684 | 494 | 74,826 | 15,564 | 15,564 | 3,79,860 | 8,79,860 |
One can easily make out from the above two tables, both investors were having same capital at beginning of their journey but the smart investor had ended up with a much higher amount than the traditional investor even though their return on capital is also presumed the same. However, debt funds consisting only AAA rated papers are having at least 1.5-2% higher return than Term Deposits, but, this article has been written with the objective to explain how taxation can be turned into wealth creator, hence, the higher return is being ignored.
We can easily draw the following conclusions by a bird’s eye view on both the tables simultaneously.
1. From 2nd Year onwards smart investor has started out playing the traditional smart and has started out playing traditional investor significantly from 3rd year onwards.
2. Total Taxes paid by the traditional investor is much higher than the smart investor at the end of 10th year 1,13,046 against 15,564.
3. This principle works for each person having any tax slab rate.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. All Content in the article is the information of a general nature and does not address the circumstances of any particular individual or entity. Please discuss this with your financial advisor before making any investment decisions.
Written By
CA Kanj Goel detail [email protected]
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