RBI allows transfer from NRO to NRE account 2: Understand Tax Drag and Why transfer.

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
1 110,000 106,910 10,000 6,910 3,090 30.90%
2 121,000 114,297 21,000 14,297 6,703 31.92%
5 161,051 139,666 61,051 39,666 21,385 35.03%
10 259,374 195,067 159,374 95,067 64,307 40.35%
20 672,750 380,510 572,750 280,510 292,240 51.02%

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%
10 404,556 268,110 304,556 168,110 136,445 44.80%
20 1,636,654 718,832 1,536,654 618,832 917,822 59.73%

* 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”.

About Jigar Patel, CFA (USA), MBA-Finance (USA), CPA (USA), CA (India) Mr. Jigar specializes on NRI Investments and Taxation. He is proud to be one of only 21 CFA Charterholders in India working as consultants. (In 2011, when he became CFA Charterholder, out of 97,173 CFA Charterholders in the World, only 697 Charterholders were in India and only 3% work as consultant; Source: www.newcfa.org). He received his MBA (Finance) from University of Illinois, Chicago, USA, CPA from USA and a Chartered Accountant from India. Jigar has over 15 years of professional experience including more than 4 years with KPMG USA’s Risk Advisory Services. Currently, he provides Wealth Management and taxation consulting serving clients from USA, UK, Americas, Europe, Middle East, Asia, Africa, Australia and India.