I have been receiving lot of inquiries whether to transfer, when to transfer, whether to break NRO FD to transfer funds out of NRO to NRE accounts and many more.
My answer has been and is always going to be Break FD and Transfer funds AS SOON AS POSSIBLE provided total cost of premature withdrawal is less than the present value of future benefits (including tax saving) from NRE FD.
Factors such as term of FD, amount, maturity date, premature penalty, effective tax rate, interest differential, expected interest rate movements, whether filing return in India, what you plan to do with your funds, etc. are very much important and should be considered before making any decision.
For most of the NRIs, Income Tax on interest of NRO savings or FD account materially affects their after-tax return. If you are a long term investor, effective income tax rate is very high compared to nominal tax rate. The compounding of income tax makes effect greater than the tax rate. The effect is known as TAX DRAG. It means reduction of potential income due to taxes.
If you invest Rs. 100,000 which generates 10% return every year and if tax rate is 30.9%*, your tax drag in 5 years, 10 years and 20 years would be 35.03%, 40.35% and 51.02% (i.e. you pay more tax than your after-tax gain) respectively.
Shocked? See below for the calculation:
|Investment 100,000; Return 10%; Tax 30.90%|
|Year||Value Tax=0||Value After-Tax||Gain at Tax=0||After-tax Gain||Gain lost due to Tax||Tax Drag|
If your investment generates 15% return every year, your tax drag for 10 years and 20 years would increase to 44.80% and 59.73% respectively.
|Investment 100,000; Return 15%; Tax 30.90%|
* Finance Act 2012 requires Tax Residency Certificate (TRC) for lower TDS rates as per DTAA. If NRIs are not able to obtain TRC from the Government of their resident countries, tax will be deducted at 30.9% from April 1, 2012. I would assume that TDS will be deducted @ 30.9% and not DTAA rate of 10%-15% for most of NRIs from April 1, 2012.
While there are other advantages of transfer from NRO to NRE as noted in my blog at http://nareshco.com/blog/?p=8, the key reason for my recommendation is “Tax Drag”. Understanding tax drag is extremely important especially if you are in the highest tax bracket. Unfortunately, the concept is not known or understood by majority of bank employees, financial advisors or Chartered Accountants.
Please also review “Procedures for transferring funds from NRO to NRE”.