Taxes are boring. Wouldn’t you rather spend your time doing something more entertaining than fretting over filling up forms or understanding the tax code? But the fact is there is more to taxes than just filling forms and meeting deadlines. We need to understand that taxes are critical in contributing towards our financial security. Most people don’t give adequate importance to three important aspects: taxes and loss of purchasing power, after-tax returns, and tax planning as an integral part of financial planning.
Taxes and purchasing power
Clearly, taxes reduce our purchasing power. But this is not just in the obvious way of direct taxation through income tax. The hidden tax the government levies upon us is inflation, which is an indirect tax on our consumption. Rising prices leave less money in our pockets, making us vulnerable to an increase in living costs.
In the long run, it is important for us to maintain our purchasing power. During retirement, it is our savings, and the returns we earn on them, that will sustain us. Therefore, it is important that we save and invest in a tax-efficient manner so that we can maintain our purchasing power.
• Invest in assets that offer long-term capital appreciation: Equities and real estate are both expected to appreciate in the long run, and offer better protection against inflation.
• Hold investments for a long period: When it comes to mutual funds and equities, constant day trading and portfolio churn affects the returns and causes a huge incidence of taxation. If you hold for a longer term, chances are you will benefit from both capital appreciation as well as lower incidence of tax.
• Avoid fixed income instruments: Fixed income instruments such as FDs are the worst when it comes to protection against inflation. Also, there are taxes on interest received. You should instead invest in a balanced equity mutual fund which offers the tax benefits of an equity instrument as well as returns that will outpace inflation, along with the stability of a debt fund.
The short-term gains we make on our investments often blind us to the fact that we pay taxes on them. Also, we seldom make use of laws that protect us against paying tax on investments that did not make money for us.
• Think about the total cost of the investment: Don’t think of the investment just in terms of gain, but rather in terms of after-tax gains.
• Maintain enough liquidity to pay your tax dues: Don’t spend all your gains. You will need some cash to pay the taxman. You might end up paying a fine as well if you delay or forget your payment.
• Use tax losses to offset taxable gains: Companies do this all the time, and as individuals we too can use the tax code to offset our gains and losses.
Tax planning as part of financial planning
You need to understand how best to position your finances to make tax-efficient decisions for the long term. These decisions must be made keeping your overall financial situation and goals in mind. For instance, don’t just buy another insurance policy to save taxes unless you know the insurance coverage you need. You may end up with the wrong policy or a very expensive one.
• Can you sustain your tax-related investments? Some investment options require recurring cash in successive years; for instance, the annual premium for an insurance policy. Ensure that you will have the capacity to make these payments every year.
• Lock-ups: Some tax-related investments will lock up your money for a specific number of years. Can you afford to tie up your money for this period? Are you sure you would not have to access this cash in the interim? You might be faced with penalties if you are to withdraw your cash before the lock-up expires.
• Be creative about organizing your tax affairs: Structure your financial affairs so that certain types of income accrue to those taxpayers within your family who have to pay a lower rate of tax. This way, for a family as a whole, you can preserve the outflow of cash to the taxman. For instance, move certain types of income to your parents or spouse if they are in a lower tax bracket than you. Similarly, structure your cost to company in such a manner that your cash-in-hand pay can be maximized.
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(Kartik Varma and Dhruv Agarwala graduated from Harvard Business School and are co-founders of New Delhi-based iTrust Financial Advisors)