You got Rs. 10 lacs with you. You know you would need the money or at least some portion of it within 3 years.
Where would you invest that money? A Bank Fixed Deposit or a Debt Mutual Fund?
Let’s assume debt mutual funds have as low risk as FDs and FDs are as flexible as debt MFs. The only difference is in tax treatment. And that both return 8%.
After 1 year, you need Rs 2 lacs.
How much tax will you pay in a bank fixed deposit?
How much tax will you pay in a debt mutual fund?
Will the tax amounts be the same? After all, FD interest income and the short term capital gains in a debt fund get taxed at your marginal tax rate. Or different?
While we do this analysis, let’s assume debt mutual funds and fixed deposits are the same on all the aspects except for taxation. Let’s assume debt funds carry as low risk as bank FDs and bank FDs are as flexible as debt funds.
Interest income from fixed deposits is taxed at your slab rate (marginal income tax rate).
When it comes to debt mutual funds, there is no income tax (capital gains tax) implication until you sell MF units. If you sell the units within 3 years of purchase, the resulting capital gain is short term capital gain and is taxed at your marginal income tax rate. So, no difference in taxation between a bank FD and debt MF if you need the funds within 3 years. We will discuss an interesting point even about this later in the post.
If you sell the debt mutual fund units after holding for 3 years, the resulting capital gain qualifies as long term capital gain. The tax regime is quite benign for long term capital gains (LTCG). LTCG is taxed at 20% after accounting for indexation.
Therefore, if the investment horizon is greater than 3 years, a debt mutual fund is a better choice from the point of view of taxation, if you are in 20% or 30% tax bracket. If you are in 5% tax bracket, a bank fixed deposit will win over a debt fund.
What if I need or may need the funds before 3 years?
We discussed earlier in the post that if you need (or sell) the investment before 3 years, you can be indifferent between a debt fund or a bank fixed deposit (assuming same risk-return profile). However, that is not really the case. Let’s see how.
For debt MFs, the capital gains tax liability is only on units sold. For the units that you continue to hold, there is no capital gains tax implication.
Let’s consider an example.
Suppose you purchase debt MF units for Rs 10 lacs at prevailing NAV of Rs 100. You will get 10,000 units of the scheme.
Let’s further assume that the fund gives a return of 8% over the next year. NAV will grow from Rs 100 to Rs 108. The value of your investment will grow to Rs 10.8 lacs. You are sitting on an unrealized gain of Rs 80,000
Suppose you need Rs 2 lacs for an emergency. There is no need to redeem the entire investment. You will simply redeem units worth Rs 2 lacs.
How many MF units do you need to redeem?
No. of units to be redeemed = Rs 2 lacs/ Rs 108 =1851.9 units
Redemption of these many units will give you the required amount.
How much tax do I need to pay?
You need to pay tax only on those units that you have sold.
You have sold 1851.9 units. Since you sold the units within 3 years (after 1 year), such gains will qualify as short term capital gains. You will have to pay tax at your marginal income tax rate.
STCG = No. of units sold * ( Sale price – Purchase price )
= 1851.9 * (108 – 100) = Rs 14,815
If you are in 30% tax bracket, your tax liability will be Rs 4,445.
If you are in 20% tax bracket, you have to pay Rs 2,963 in taxes.
If you are in 5% tax bracket, you have to pay Rs. 740 in taxes.
Contrast this with Fixed Deposit
Let’s assume the fixed deposit earned the same rate of return of 8% p.a.
I assume there is no TDS on interest on FDs or any penalty for premature withdrawal of FDs. This will help me demonstrate my point better.
Your investment of Rs 10 lacs will grow to Rs 10.8 lacs at the end of the first year.
Even though you have to withdraw only Rs 2 lacs, you have to pay tax on the entire interest earned during the year
Since you earned interest of Rs 80,000, your tax liability will be Rs 24,000 (assuming you are in 30% tax bracket).
Now, you need to compare.
In case of debt mutual funds, your tax liability would have been only Rs 4,445. In the case of fixed deposits, your tax liability will be Rs 24,000. TDS and penalty on premature withdrawal will further tilt the balance in favour of debt mutual funds.
Do note if you were in 20% tax bracket, the tax liability will be Rs 16,000. If you are in 5% tax bracket, the tax liability is Rs 4,000 in case of a bank fixed deposit.
How should you use this information?
You would have read at many places that if the investment horizon is less than 3 years, it does not matter whether you invest in debt mutual funds or bank fixed deposits.
However, many times, we do not know when we will need the money or how much we will need. For instance, if you are accumulating an emergency corpus or medical fund, the nature of the goal is such that you do not know when you will need money or how much you will need.
You may need the money within a week or you may not need the funds in many years. And when you need it, you may need the entire amount or you may need less than a quarter of it. You do not know.
It is in such cases, as demonstrated above, debt mutual fund is a better choice (purely from the perspective of taxation).
Do note you need to pick up the right variant of debt mutual fund too. Not all debt mutual funds offer FD like returns (and no debt fund is virtually risk-free like a bank FD).
Despite establishing this tax advantage, I suggest that you stick with bank fixed deposits if you are in 5% tax bracket (or do not have any taxable income). The risk of debt funds may not be worth it. We must also note that the unsold MF units have accumulated capital gains. If you hold on to the units for over 3 years, you will be taxed at 20% after indexation (even though you are in 5% tax bracket). For instance, in the above example, the remaining 8,148.15 units have an NAV of 108. Let’s say you sell these units after completing 3 years and CII has grown by 4% each year, the total tax liability will be ~Rs 22,000 (20% after indexation). An effective tax rate of 10.3%. By the way, this is over and above tax of Rs 740 that you would have paid while redeeming Rs 2 lacs. With FD and a marginal tax rate of 5%, you would have paid only Rs 4,000 per year (a total of Rs 12,000 over 3 years).
Simple Thumb Rule
If you are in 0% or 5% tax bracket, stick with bank fixed deposits. Plan your deposit maturity smartly.
For those in 20% or 30% tax bracket,
- If you know that you won’t need the money in 3 years, stick with debt funds (assuming you can pick the right fund)
- If you know that you will use the entire money in 3 years, you can pick either (assuming you can get the maturity of your FDs right)
- If you are not sure if you will need the money in 3 years or if you will need the money in parts, go with a debt fund (assuming you can pick up the right fund).
Point to Note
Bank fixed deposits have a few advantages over debt mutual funds. The biggest is that bank FDs are so easy to understand and carry a much lesser risk. I have not met an investor yet who does not know how FD works. On the other hand, debt mutual funds come in multiple variants and it is not difficult to pick up a wrong variant.
Understand the product before investing.
If you still cannot make up your mind, seek professional help from a SEBI Registered Investment Adviser.
The post was first published in February, 2017.