Maximizing Wealth The Smart Way – Managing Tax Drag And Building Risk-Adjusted W

1. Maximizing Wealth The Smart Way – Managing Tax Drag And Building Risk-Adjusted Wealth When it comes to investing, most individuals focus on returns without realizing that what truly matters is not the gross return but the after-tax return. The prime objective for investing in India is to increase the risk-adjusted after-tax return. The key is the AFTER-TAX return. While an investor may think, everyone pays income tax and it is a part of the investment, tax means money out of his pocket that is not coming back. It is very important to understand the effect of tax on the return. This is where the concept of tax drag becomes crucial. Understanding Tax Drag Taxes are not just a one-time deduction from your income. They eat into your investment growth year after year, reducing your compounding potential. The compounding effect of tax is always higher than the actual tax rate and is known as “Tax Drag”, which increases with time and rate of return. For example, if Mr. Siddharth from Singapore, having a marginal tax rate of 30%, invests Rs. 100,000 in an NRO bank FD, earning 10%, his gross income, tax and net income would be Rs.10,000, Rs.3,000 and Rs. 7,000, respectively. If he continues this investment for 1 more year, his after tax return for 2 years would be Rs. 14,490 (Rs. 7,000 + Rs. 7,000 + 7% on Rs. 7,000). Had his investments been

2. all tax free, he would have made Rs. 21,000 (Rs. 10,000 + Rs. 10,000 + Rs. 1,000). His loss due to taxes in 2 years would be Rs. 6,510 (Rs. 21,000 - Rs. 14,490), increasing his tax to 31% (Rs. 6,510/ Rs.21,000), even if his marginal tax rate is only 30%. As the tax drag is 58.6%, you end up paying more to the government than yourself. If the investments were done in a tax-free manner, the return could be 141% (900,000/636,623). Why taxes matter in investments Taxes are very important for your investments. It is thus important to understand the concept of tax drag and plan your investments accordingly. Higher the investment horizon, higher the tax drag. Higher the return, higher the tax drag. Plan your taxes, DO NOT avoid any taxes. Tax authorities have evolved and are using information technology to collect and analyze the data and also issue notices. By factoring in the tax drag early on, investors can better estimate the true growth of their portfolio and avoid overestimating their wealth accumulation potential. The concept of risk-adjusted after-tax return An investor has to take higher risk to earn higher return but higher risk does not guarantee higher return. Also, it is prudent to expect higher return as the risk goes high, even within an asset class. For example, if the expected annualized return (net of expenses) from an equity mutual fund is 12%, it should be 15% from direct shares of companies, 18% from Portfolio Management Scheme (PMS), 21% from Alternative Investment Fund (AIF) and 24% from Private Equity (PE) / Venture Capital (VC) investments. But not all returns are equal when it comes to taxation. Some structures allow taxes to be deferred, while others realize them regularly. Taxation differences across investment options When evaluating investment avenues, it is not enough to compare only their headline returns. The timing and manner of taxation can significantly influence how much wealth ultimately stays in your pocket. Different investment structures – mutual funds, PMS, AIF, or direct equity – are taxed in different ways, and this changes the long-term outcome because of the tax drag.

3. The PMS would buy and sell on your behalf so capital gain is generated on which the investor would have to pay the tax. Similarly, the AIF life is 5 or 7 years so all gains are realized and the tax is to be paid. For mutual funds, when the fund buys or sells the securities, there is no tax. The tax is paid only when the investor sells the fund. So, for a long- term investment, if the investor does not sell for 20 years, he/she would not pay any tax. And the tax would be long term capital gain only. PMS and AIF would also have interest, dividend as pass through income which is taxed at slab rates and long term and short-term capital gain taxed at respective rates. Even if the tax rate is same, say 12.5%, because mutual fund can delay paying tax, the compounding effect of tax (tax drag), would negatively impact the return by at least 2-3 % in PMS and AIF compared to mutual fund. As a result, 12% return on an equity mutual fund is better than 14% from direct equity or 16% return from PMS or 18% from AIF on a risk adjusted after tax basis. Why risk management matters To increase the return, higher risk is taken. If the price goes down, it takes a lot higher return to recover the same loss percentage. For example, to recover 25% loss (100 to 75), gain of 33% (75 to 100) is required and to recover 40% loss (100 to 60), gain of 67% (60 to 100) is required. If an investor can control the drawdown, s/he can recover quickly and grow the portfolio in a more systematic and sustainable way. Also, as explained in Tax Drag, income tax significantly reduces the value of investments over time. So, it is critically important to plan for taxes and grow the wealth at a reasonable return. Key recommendations for investors On Managing Tax Drag Taxes are very important for your investments. Understand the concept of tax drag and plan your investments accordingly. Higher the investment horizon, higher the tax drag. Higher the return, higher the tax drag. Plan your taxes, DO NOT avoid any taxes. Tax authorities have evolved and are using information technology to collect and analyze the data and also issue notices.

4. On Risk-Adjusted Returns Have clear expectations of risk and return – Higher the Risk, Higher the Expected Return. Risk adjusted after-tax return is better than return at any risk. Invest in a security that gives higher return at same level of risk. Invest in a security that has lower risk for same expected return. Consider after-tax return for investing and growing wealth. Most investors focus on returns without realizing that after-tax returns tell the true story of wealth creation. As seen in the case of tax drag, even a small difference in taxation treatment can create a massive long-term impact on your portfolio. Risk management is equally critical. Higher risk does not always translate into higher returns, and drawdowns can be devastating without a systematic strategy. By balancing risk and tax planning, investors can maximize their risk-adjusted after-tax returns and grow wealth sustainably. The key lies in informed planning – choosing the right investment vehicle, being aware of taxation rules, and keeping an eye on how compounding works both for and against you. While investors can take steps to understand tax drag and manage risk, professional advice often makes the difference between good and great results. NRIs, in particular, face additional challenges due to dual taxation and compliance reporting. ExpertNRI, trusted as a premier NRI tax consultants India, offers end-to-end support in tax planning, compliance, and investment structuring. With their guidance, investors can focus on wealth creation while leaving the complexities of tax optimization to professionals. Read more article: Maximizing Wealth The Smart Way – Managing Tax Drag And Building Risk-Adjusted Wealth