Are you tax aware? Premium

Discover how mass-affluent investors can enhance tax efficiency through strategic asset allocation and investment decisions.

You are a tax-aware investor if you actively integrate the impact of taxes into all investment decisions. Should you? In this article, we discuss what it takes to be a tax-aware investor.

The rich are typically tax-aware investors. The asset management industry refers to them as High Net Worth Individuals (HNWIs), which include Very HNWI and Ultra HNWIs. The middle-class span a wide range of wealth, where the top-end of the spectrum could be tax-aware investors. So, a large part may not be tax-aware investors. The middle-class is typically referred to as mass- affluent investors.

The investment process starts with the asset allocation decision. This involves deciding how much of your expected annual savings should be allocated to each asset class you intend to invest to achieve life goals. The next step is the asset location decision. This refers to deciding how to invest in a tax-efficient way to achieve the asset allocation decision. This is based on three locations- taxable, tax-deferred and tax-exempt. The tax-exempt location includes provident fund, public provident fund and national pension scheme. All capital appreciation products fall into the tax-deferred location, where tax liability arises only when you sell the investment. The rest falls into the taxable location.

Most mass-affluent investors must choose from the three locations. Some mass-affluent investors and typically all HNWIs create tax shelters, in addition to using investments that directly fall into these three locations. Setting up tax shelters may be optimal only beyond a wealth level. So, for most mass-affluent investors, the goal must be to align asset allocation to achieve their goals even if some investments are taxable. If you want capital appreciation along with stable income, invest in equity funds and bank deposits. The former will fit into tax-deferred location and latter, the taxable location. While tax on accrued interest will hit the bond exposure in portfolio, there is the benefit of diversifying source of returns.

Most mass-affluent investors may not have the choices available to HNWIs. The decision to invest tax-efficiently is nevertheless crucial. So, they should first decide on asset allocation. Then, check if bond asset-class exposure can be in a tax-exempt location, given the objective to earn income returns with minimal reinvestment risk. If not, they may have to choose the taxable location. The trade-off is the tax incurred for lowering the reinvestment risk.

(The author offers training programmes to individuals for managing their personal investments)