Success in personal finance is based on some simple practices followed by individuals over a long period of time. Charlie Munger has summarized it well in 15 words:
Spend less than you make; always saving something. Put it into a tax-deferred account.
I often feel people under-appreciate the importance of tax deferral for their investments. I have created a small calculation which highlights how tax-deferral in itself has a huge impact over the long term.
Let us discuss two tax systems applicable to investments:
Accrual Based Taxation: In the above taxation one has to pay tax on the income generated every year and the actual tax is not dependent on whether an investor has redeemed his money. A simple example for this is a fixed deposit where you pay tax on an annual basis irrespective of maturity/redemption of fixed deposits.
Cash Basis of Taxation: Under this taxation structure tax applicability is based on actual redemption/maturity. An investor does not need to pay tax unless he makes an actual redemption. This helps an investor to take advantage of deferred tax until he redeems his investments. Some examples of such instruments are NPS (National Pension Scheme), Mutual Funds (MF)
Now let us assume two individuals earn a similar return over a period of 30 years which is 15% and are taxed at the same rate which is 30% of the income.
Investor 1: Ramesh: An investor invests 10lakhs in an investment instrument (say FD) at 15% for 30 years and is being taxed at 30% every year. (Applicable taxation is accrual basis)
Investor 2: Rakesh: An investor invests 10lakhs in an investment instrument (say MF or NPS) at 15% for 30 years and is being taxed at 30% only at the end of 30 years. ( applicable taxation is cash basis)
When we run these investments over 30 years we realize the importance of deferred taxes on long term investment portfolio. Let us see the results:
Ramesh will receive Rs. 1.81 cr. and which translates to a CAGR return of 10.50% (post-tax). Rakesh will receive Rs. 4.06 cr. and which translates to a CAGR return of 13.61%. (post-tax). That’s a whooping difference of 2.2 cr. just because of deferred tax advantage.
So, what we conclude from the above example is that a simple deferred tax advantage available to us as investors if understood well and implemented in accordance to our long term financial goals will have a significant difference to our long term wealth.