Jigar M. Patel
International Tax Attorney
Evaluating Your Pre-Tax and After-Tax Returns
The most common mistake an ordinary investor makes in the choice of his investment is in jumping for a higher rate of interest, without taking into consideration the effective after tax return keeping in view the marginal rate of income-tax on his total income. Similarly, it is not uncommon to see an investor in a high tax slab who is unable to appreciate the worth of a tax-free investment, the break-even rate of interest or the pre-tax return of which is in fact much higher than the seemingly low rate of interest attached to the investment.
Are you prepared to accept the fact that if your income is liable to income-tax in the tax slab of 31.2% you would be much better off with a 7.1% tax-free return as compared to a 9% return which is taxable? If you are not, the following illustration should convince you beyond doubt:
Illustration: Your investment of Rs.1,50,000 in PPF would fetch you an interest of Rs.10,650 @ 7.1% per annum. Since you do not have to pay any income-tax thereon, the entire Rs.10,650 remains with you. If this amount is invested in a deposit earning taxable interest @ 9% per annum, you would no doubt earn a higher return of Rs.13,500 on the above investment. But considering the fact that you would have to pay income-tax of Rs.4,212 @ 31.2% on the interest earned of Rs.13,500, you will be ultimately left with a saving of only Rs.9,288.
Measuring Your Effective Yield
In terms of ‘measuring your effective yield,’ in the above case your tax-free return of 7.1% works out to an actual break-even pre-tax return of 10.32% (which would be equivalent to an after-tax return of 7.1% applying your marginal tax rate of 31.2%). This naturally compares more favourably with the given choice of 9%. To put it the other way round, your taxable return of 9% works out to an effective after-tax return of 6.192% (considering your 31.2% marginal rate of income-tax), which still cannot match the alternative of the 7.1% return which is not subject to income-tax.
A prudent investor should always compare the break-even or effective return on his investment keeping in view his marginal rate of income-tax, while making the choice of his investment. It must also be borne in mind that such comparison of pre-tax or after-tax returns is bound to vary keeping in view the marginal tax rate of the concerned investor.
To illustrate, the effective rate of interest after tax on a taxable return of 12%, at different income-tax slabs in the case of an individual for Assessment Year 2024-25 under the new tax regime would be as under:
EFFECTIVE RATE OF INTEREST AFTER TAX
FOR A TAXABLE RETURN OF 12%
Income range Rate of tax Effective rate of
(Rs.) (IT+SC+EC) interest after-tax
Up to 3 lakhs Nil 12.00%
3 lakhs – 6 lakhs 5.20% 11.376%
6 lakhs – 9 lakhs 10.40% 10.752%
9 lakhs – 12 lakhs 15.60% 10.128%
12 lakhs – 15 lakhs 20.80% 9.504%
15 lakhs – 50 lakhs 31.20% 8.256%
50 lakhs – 1 crore 34.32% 7.882%
1 crore – 2 crores 35.88% 7.694%
2 crores and above 39.00% 7.32%
