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.
Read: Bank Fixed Deposit vs. Debt Mutual Funds
Taxation of Fixed Deposits and Debt Mutual 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.
Moreover, the tax advantage is one part. Do appreciate the risk associated with debt funds before taking a decision. Pick the right debt fund.
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.
20 thoughts on “Need money within 3 years: Bank FD or a Debt Mutual Fund?”
Wouldn’t an equity Arbitrage fund be even better in this case?
Equity Arbitrage fund is a very different product. I agree it gets tax treatment of an equity fund but pre-tax returns can be lower than even liquid funds.
Regarding Debt fund Of HDFC FMP 1150Feb2017(1). It claims that fund as potential to reduce tax on long term capital gains by availing benefits of 4 indexation over 5 financial years.
It is very difficult for me to understand as your post says indexation benefit only after 3 years.
HDFC help line unable to explain, hence I would be greatful if you could explain.
2) Debt funds claim to give assured return. but for my recent investment in HDFC Gilt Long Term Plan , it is showing negative returns. Cannot understand this economics
FMPs should be avoided. You can create similiar tax pattern in a normal debt fund without such restrictions on liquidity.
Yes, you get indexation benefit if you hold capital asset for a MINIMUM three years.
You can always hold for longer periods and still get tax benefits.
If you invest on March 31 2017 and redeem on April 1, 2021, you have invested for 4 years. However, from taxation purpose, you invested in FY2017 and redeemed in FY2022. Therefore, you get indexation benefit for 5 years.
Btw, this you can do with any debt mutual funds. FMP makes for a poor choice.
As I mentioned in the post, not all debt mutual funds provide FD like risk and return profile. NO debt fund provides assured returns.
Long term debt funds (like the one you hold) carry interest rate risk and can go down when the interest rate rise. Markets move not just on occurrence of event but even on expectation of an event. Bond prices had gone up expecting a repo cut. Repo cut didn’t happen and RBI commentary tapered such expectations.
Suggest you seek professional assistance.
Thanks a lot
You are welcome.
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Deepesh,
Thanks for your article. What would be the best Debt Fund option for next 3-5 years when interest rates are going to increase and which would give returns between 8 and 10% annually.
As per my findings Long term GILT funds are good option when interest rates are decreasing and will give returns above 10%, but really not able to find good option when interest rates are increasing.
Thanks
You are welcome, Paresh.
If you feel interest rates are going up, it is better to stick with lower duration funds.
I will stick to ultra short term debt funds that invest in high credit quality securities.
Please understand debt funds provide market linked returns and returns are not guaranteed.
You can also pick up short term gilt funds (there will be no credit risk in gilt funds).
Will appreciate if you could share the post with your friends on Facebook and Whatsapp.
Can you consolidate the terms under categories short ultra short long
We have lot of terminologies say floating . treasury and lot more
Though implied, the post should have highlighted that one should invest in debt oriented mutual funds under growth option as the dividend option entails 28% dividend distribution tax which goes from the investor’s nav
Right, Arvind.
However, there is no thick and fast rule that one should invest in growth option in debt funds.
I can easily see cases dividend re-investment option may be a better choice. Consider those in highest tax bracket and those with income over Rs 50 lacs (even surcharge needs to be paid). For short term investments in such cases, dividend re-investment is a better choice than growth.
just for the sake of defending fd method, one can deposit multiple fd of 2L each so that all may not be withdrawn. can we still compare then.
and if we consider in a sip type mode of investment:
fd will be always a new one so it can be withdrawn separately as per our choice first in first out last in first out. but how does mutual fund units withdrawal take place?? fifo or lifo??
Taxation does not change if you open multiple fixed deposits.
It will affect only penalty for premature withdrawals from fixed deposits.
With MFs, it is FIFO.
Your article has helped me decide to go for debt mutual funds over bank FDs,I found a website where they are recommending debt mutual fund for the same purpose rupeevest[DOT]com/Mutual-Funds/Portfolio-Investment/Design/40. Can you share your views on the same?
Debt funds have different risk-return profile as compared to fixed deposits.
Believe it is naive to just look at returns.
My income was below taxable level (within exemption limit), and I had chosen a good debt fund and sold in less than one year as I needed money but when my return was filed, I had to pay short term capital gain tax as per my lawyer’s advice. Can I refile the return and claim the tax paid now? (IT has already reviewed my return and returned the rest of the excess tax paid as per my return other than above which I have wrongly paid and not claimed).
How much fees you charge for yearly advice for mutual fund selection and for replying to some queries in a year – related to individual taxation. (similar to articles published by you but some more clarifications – once in a while). Can you please advice for a small client – yearly per hour or couple of emails per month – what would you charge for proper advice on individual taxation and mutual fund selection or for review of portfolio. Say maximum 5~10 hours work (or lesser) in a year for someone in your office. I am interested in such service, if charges are reasonable.
Hi Sudhir,
Please talk to a CA. He will help you with taxes.
I am an investment adviser. you can refer to “Our Offerings” page on the website.
“If you feel that you will need to break your investment before it reaches maturity and liquefy funds at short notice, then invest in debt mutual funds. But bear in mind that you will never receive the full benefit from any form of investment if you habitually break investments.
If your investment pattern involves allowing all your well-planned and premeditated investments to fully reach maturity – and make full use of the huge maturity benefits – then invest in fixed deposits. Once an investment has been made, it is assumed that enough precautions and measures have been taken to allow for full returns.”
Hi Deepesh,
Howz about the security of FD’s, i mean there was a provision suggested that insurance of amount deposited in banks would be increased to 5 Lacs … has it been implemented & does it cover small finance banks as well. Would be greate of you can share any link where this can be checked.
Regards
Nitin .
Hi Nitin,
Yes, these two links will help clarify.
https://m.rbi.org.in/Scripts/FAQView.aspx?Id=64
https://www.paytmbank.com/Policies/Comprehensive-Deposit-Policy-for-Paytm-Payments-Bank