Tax avoidance is the legal usage of the tax regime to one’s own advantage, to reduce the amount of tax that is payable by means that are within the law. (Tax avoidance is legal, tax evasion is not)
Managing taxes well will help us keep more of our money. We should realize that the people who build wealth are aware of taxes and are able to leverage this knowledge to their advantage. The very rich often pay a lower rate than others – here is a link to an article were Warren Buffett talks about him paying a lower rate than his secretary.
Let’s look at impact of taxes, if you are planning to save Rs 100,000 post tax and you are in the 30% tax bracket, you will have to earn 142,857 pre-tax. Now let’s look at the impact over a period of time.
As you can see from the chart, Rs 100,000 invested at 10% interest for 40 years at zero tax becomes 4,525,926 and the same amount at 30% tax becomes 1,497,446. If you can avoid taxes you would be 3 times richer!!! As we can see from the chart, the longer we invest the greater is the difference.
The key here is to understand the tax implications of various products. Governments typically encourage long-term investments and provide significant tax advantages for those who invest for long-term. In India, if one invests in stocks for over one year then there is no long term capital gains tax!!!
This has 2 implications – let’s say a person is in a 30% tax bracket
- If she is looking at long term investment, the tax advantage given to equities becomes a serious proposition for wealth creation. Equities generating 7% per year become more attractive than fixed deposits (FD’s) paying 9% interest as FD’s are taxable. So she finally is able to keep only 6.3% in FD as opposed to all 7% in equities. The magic of compounding will start to make the differences wider over a period of time. We should not forget that the dividends from equities also do not attract any taxes.
- If she is a trading often (even if she buys and sells a security with-in the same calendar year), then she has to earn 142,857 in profits to keep 100,000. Whereas if she is an investor, (holding the security for over a year!), then she needs to earn only 100,000 as she gets to keep all of it.
In summary, if you have funds that you can invest for a long term, then you should seriously consider investing in equities as the tax advantages for dividends and capital gains will help build wealth much faster.
Now coming to death avoidance…. may be another day :-)