Previously in this column, we discussed the trade-off associated with investments in cumulative fixed deposits and recurring deposits. To recap, both deposits help moderate reinvestment risk but attract taxes on accrued income. In this article, we discuss the impact of taxes on interest income at a granular level.

Tax Drag

Suppose you invest one lakh in a five-year cumulative fixed deposit that compounds interest at 6 % per annum. Your maturity value is 1.33 lakh without taxes. But if you consider 30% tax on your accrued interest annually, your post-tax return is 4.2% (70% of 6%). Compounding this return over five years will accumulate 1.23 lakh. The difference between the maturity value without taxes and with taxes is 10,982 (1.33 less 1.23). Dividing this amount by 33,000- the returns without taxes (1.33 lakh less one lakh capital) — you get 32.5%. This captures the effect of taxes on returns and is referred to as the tax drag.

It is important to understand the implication of the above calculation. One, tax drag increases with your marginal tax rate. That is, individuals with a marginal tax of 30% will suffer a greater tax drag than individuals with a tax rate of 20%. Two, given your tax rate, you will suffer a larger tax drag the longer your investment horizon. That is, an investment with 10-year time horizon will suffer larger tax drag than an investment with, say, an 8-year time horizon. This leads us to the third argument- greater the pre-tax return on an investment, larger the tax drag.

The upshot? You must actively look for avenues to protect your interest income from taxes, especially if your investment horizon is long. For instance, maximising your investments in provident fund and public provident fund would help you protect your interest income from taxes for investment horizon of 15 years and above. This would be optimal for your child’s education fund and for your retirement portfolio.

Conclusion

It is important to protect your portfolio from reinvestment risk. But such investments suffer from tax drag. If you are more concerned about tax drag than reinvestment risk, you should consider investing in gilt funds. The tax drag on these mutual funds is lower because you will pay taxes only when you realize your gains. Also, the tax rate will be lower. But your investments will be exposed to downside risk.

(The author offers training programmes for individuals for managing their personal investments)

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