LTCG Tax impact on Early Retirement

Starting with the recent budget , you have to pay 10.4%(including cess) long-term capital gains tax(LTCG) on gains when you sell mutual funds or stocks after holding them for 1 year.

taxJPGimage source

What does this mean for your Early Retirement plans?

  • Not the end of the world actually! If you are selling after holding for 25 years and your return was 12% then after paying LTCG tax your return falls to 11.54% : a negative impact of only 0.46%
  • Deepesh from personalfinanceplan.in has done a fantastic job of showing the impact of the tax on different CAGR % for corpus held over different lengths of time.  I’m using an image from his article below:Impact on your CAGR due to tax on LTCG. source - personalfinanceplan.in
  • As you can see above, the longer you hold, the lesser the impact of the tax which is perfect for the Early Retiree. For example: At 12% expected return, if you hold only for 5 years then the return falls to 10.99% due to tax but if you hold for 25 years the return only falls to 11.54%.

What Should You Do?

  • If you were expecting 12% returns from equity over 25 years then reduce your expectation to 11.54% and use the Early Retirement Excel calculator to calculate the increase in SIP required.
  •  If you want to retire early at the same age as before this tax then you’ll have to increase the SIP amount. Just increase your SIP and don’t think any more about this tax.
  • I’ve added a tab to the Early Retirement Excel Calculator so you can calculate the impact of LTCG tax on your expected returns %.

What Charlie Munger has to say about LTCG tax:

Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum.

In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15%—or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

Charlie Munger, USC Business School, 1994

 Impact on our family’s early retirement plans:

  • It will take us 1 extra year to achieve our Early Retirement target if we continue our current SIP amount. I’m actually relieved that the tax impact is only 1 extra year 🙂
  • Last month I posted that we had achieved 38% of our early retirement target. Our target is now reduced to 34% after factoring in LTCG. Remind me never to post a target achieved % before the government announces its budget 😉
  • This new tax only confirms my belief that to deal with Life’s uncertainties like this new tax you need to keep working and saving whatever you can even after reaching your target early retirement corpus. Today capital gains is set at 10%.  Who knows, it may be raised to 30% over the next 25 years.
  • The biggest positive impact is that this new tax has validated our approach of letting our early retirement corpus compound for 25 years instead of trying to live off of the returns every year which would incur a 10% tax every year!! In our approach we would only pay a one-time tax of 10% at the end of 25 years. Re-read Charlie Munger’s statement above to understand what a big difference this makes.

Special thanks:

  1. livemint : for first planting the doubt in my mind that I might be over-estimating the impact of this tax.
  2. phreakv6  : for the Charlie Munger speech that pointed me in the exact direction
  3. basuvinesh  : for calculating the tax impact with a real example.
  4. My wife : for giving me the simple idea to use Excel to calculate the exact post-tax CAGR %  when I was trying to wrap my head around its impact on our unique early retirement plans which was not getting covered in the mainstream media.
  5. deepesh raghaw : for the image I used earlier. his calculations matched my excel calculator including munger’s example so I’m confident of publishing this article and the excel 🙂 I especially agree with his quote below:

Fall from 10% p.a. to 9.49% p.a. may not look like much. However, when we talk about many years of compounding, the impact is going to be sizeable.

I have read accounts where many experts have mentioned that the impact is going to be minimal. That’s clearly not the case. Most of us shifted from regular to direct to save this extra 0.5-1% p.a. of the expense ratio. Didn’t we?

Therefore, let’s not fool ourselves. There is going to be an impact of LTCG taxation. Let’s accept it and pay the taxes happily.

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