The Basics of Taxation for investors
Income earned as a result of investments may be taxable. The impact of taxes on investment returns can be substantial and can potentially play a significant role in investment strategy. It is possible to minimize the impact of taxes through tax-planning. Thus, all investors should understand the basics of taxation and the tax laws that apply to them.
Marginal Tax Rate
The tax rate applicable to every additional dollar of income earned is called the marginal tax rate. If a country’s tax rates are as follows:
The marginal tax rate applicable to a person whose income is $68,000 is 10%.
Tax on Dividends and Interest
Income earned as dividends from stocks or interest payments from bonds, bank deposits etc is usually subject to taxation. The tax rate applicable depends on the tax structure of the country of which the investor is a resident. Some governments tax dividends and/or interest at a lower rate than other types of income, thereby giving investors the incentive to own stocks and/or interest bearing securities.
For example, dividends are taxed at 15% p.a. in USA for most investors while dividends are not taxed at all in Hong Kong!
Capital Gains Tax
A capital gain is total increase in the value of an asset. If a stock is purchased at $10 and its value increases to $15 over the course of 1 year, the total capital gain is $5.
If the investor sells this stock, the capital gain is considered a realized capital gain. If the investor continues to hold the stock at the end of the year, the capital gain is considered an unrealized capital gain.The tax payable on capital gains is called capital gains tax. Most countries tax capital gains at lower rates than other types of income.
Realized and unrealized capital gains are usually taxed at different rates by most countries. Most countries also tax long term capital gains at a lower rate than short term capital gains.
Wealth Tax
Wealth tax is the tax imposed by some governments on the net assets of its citizens. Taxable wealth may include property, houses, stocks, bonds and other securities. The laws pertaining to wealth tax vary widely from county to country. Fortunately, wealth tax rates are generally much lower than income tax rates and are typically in the order of about 1% p.a. For example, the maximum wealth tax applicable in Switzerland is about 1.5% of net assets p.a.
Tax Drag
Tax drag is the decrease in possible income due to taxes. An example would best illustrate the concept of tax drag.
Illustration-Tax Drag
Assume that a mutual fund yields 8% annually and that the income from the investment is re-invested in the same fund. Ashish Mishra invests $100,000 in this mutual fund. Assuming that no taxes are applicable, his investment would be worth $215,892 in 10 years.
Calculation
((1.08) ^ 10) X 100,000 = 215,892
Suppose the income from mutual funds is taxed at 20%, Ashish would have a post-tax income of $6,400 at the end of the first year and thus would only be able to re-invest the said amount at the end of the first year( As opposed to $8000 assuming no taxes). This results in a reduction in the 2nd year’s income. The income lost is not only the tax paid but the potential interest that could be earned on the tax.
The following table shows the income, tax paid and the future value of the investment in the scenario where there is no tax and in the scenario where there is a 20% tax payable every year.
Note that the total potential income lost due to taxes, i.e. tax drag is $29,934, which is more than the total tax paid ($21,490).
Tax Planning Strategies
It is possible to minimize the impact of taxes through careful planning. The following simple strategies can go a long way in minimizing tax drag:
- If unrealized capital gains are not taxed, delay selling your asset and realizing the capital gain for as long as possible. Do also consider the risk of the fall in market price before making your decision.
- Consider using a tax-deferred account such as a retirement account (available in some countries)
- Always use after-tax returns while making decisions about investments.
- In the event that long-term capital gains are tax exempt (e.g. India), consider holding stocks for long periods to avoid capital gains tax.
- Also consider tax-exempt bonds issued by your local government (e.g. some RBI bonds in India, certain Municipal bonds in USA)