Previously, in this column, we discussed that income-generating investments must earn compounded annual return through the time horizon for a life goal. Investing in a product that automatically reinvests annual interest income is the simplest way to compound returns. In this article, we discuss the cost of investing in such income-generating products.
Annual taxes
From a tax perspective, there are two advantages in investing in capital- appreciation products. One, you are required to pay taxes only when you realise gains; income is taxed on accrual basis. And two, long-term capital gains tax is lower than taxes on income returns.
Under the new tax regime, the marginal tax rate on interest income is 30% when total income is above ₹15 lakh; long-term capital gains is 12.5% if your annual capital gains exceeds ₹1.25 lakh.
The above two factors should deter investing in income-generating products. But there is more to investing in such products than the low post-tax returns. A behaviourally optimal approach to diversifying your portfolio is to invest in equity funds and recurring deposits (RDs)— capital-appreciation and income- generating products.
So, investing in income-generating products should not be the bone of contention. Rather, the fact that you must pay taxes on accrued income is the issue. That is the cost you must incur to moderate reinvestment risk — the risk you may not find investment avenues to compound return should the bank credit savings account with annual interest.
That said, it is important to look for tax-exempt income- generating assets. Annual investments in Public Provident Fund (PPF) will not be eligible for a deduction up to ₹1.5 lakh annually under the new tax regime. But, still consider investing in PPF as interest income is tax exempt as is maturity value of the investment.
Conclusion
Investment decisions need a trade-off. RDs attract taxes on accrued income but moderate reinvestment risk. Capital-appreciation products suffer downside risk but enjoy lower tax rates.
Allocation to equity funds and RDs must be the function of required return to achieve a goal, time horizon, savings amount, and the amount you need at the end of the time horizon to achieve the goal.
Also, the decision to invest in income-generating products must consider the stability they add to your portfolio returns, another reason to tolerate their low post-tax returns.
(The author offers training programmes for individuals to manage their personal investments)