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When investors plan for long-term goals such as funding a child’s education or buying a home, they often focus on returns, inflation and the size of the corpus required in the future. However, one crucial factor is frequently overlooked: taxes.
Financial planners refer to the amount needed at the end of an investment journey to achieve a specific goal as “terminal wealth”. This final corpus should ideally be sufficient to meet the target expense even after accounting for taxes.
Ignoring the tax impact can create a gap between expectations and reality. While estimating future costs may appear straightforward, incorporating taxation into long-term financial planning is often far more complex.
Understanding Terminal Wealth
Terminal wealth is the amount an investor needs to accumulate by the end of a defined time horizon to fund a financial objective.
Consider a parent planning for a child’s college education 10 years from now. The first step is to identify the current cost of the course or institution the child is likely to attend. A similar approach applies to goals such as purchasing a house, where the present cost of the desired property must be established.
The next stage involves estimating inflation associated with that goal. For example, education costs may rise significantly over time. By projecting the future value of today’s expense using the expected inflation rate, investors can estimate the corpus they will need when the goal arrives. That projected amount represents the terminal wealth required for the objective.
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Why Taxes Matter In Goal Planning
While calculating future costs is relatively straightforward, taxes can complicate the picture.
The final corpus should be large enough to fund the intended goal after any applicable taxes have been paid. In practice, however, estimating the tax impact over a long investment horizon is not easy.
One reason is that many individuals allocate part of their portfolio to bank deposits or bonds. Interest earned from deposits is typically taxed every year on an accrual basis, reducing the effective growth of the investment over time.
The Impact Of Tax Drag
Taxes reduce investment returns, a phenomenon commonly referred to as “tax drag”.
Apart from annual taxation on fixed-income investments, investors may also face tax liabilities while managing their portfolios. For instance, many investors begin rebalancing their portfolios several years before a financial goal is due.
Rebalancing often involves shifting money from equities to safer assets. Such transactions can trigger long-term capital gains tax on equity investments. As a result, taxes can erode portfolio returns during the final years leading up to a goal.
Managing The Effect Of Taxes
One way to account for tax drag is to estimate how the portfolio’s equity and debt allocation will evolve throughout the investment period.
Investors can then incorporate the likely tax impact arising from rebalancing and annual taxation into their future value calculations. This approach helps create a more realistic estimate of the corpus needed to achieve the goal.
However, such detailed calculations can make the investment process more complicated and may discourage investors who prefer simplicity in financial planning.
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A Simpler Approach To Building A Buffer
An easier alternative is to build a margin of safety into the target corpus.
Rather than attempting to estimate every future tax liability, investors may consider adding roughly 10 per cent to 15 per cent to their pre-tax terminal wealth requirement. This additional buffer can help offset the effect of taxes over time.
Another option is to address any shortfall at the end of the investment horizon through surplus cash or additional borrowing if required. While taxes are often overlooked during goal planning, recognising their impact early can help investors arrive at a more realistic target and improve the chances of meeting important financial milestones.
