I have already covered the most aspects in my earlier post on Bank Fixed Deposits vs Debt Mutual Funds. In this post, I will discuss a very specific case when you need to withdraw money before 3 years. In such a case, which investment product should you choose? Debt MF or a Fixed Deposit?
Taxation of Fixed Deposits and Debt Mutual Funds
Interest income from fixed deposits is taxed at your slab rate (marginal income tax rate).
There is no income tax (capital gains tax) implication until you sell your debt mutual fund 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.
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 inflation.
Therefore, if the investment horizon is greater than 3 years, debt mutual fund is better choice from the point of view of taxation.
Please understand debt mutual funds come in multiple variants and not all variants provide FD like returns. And I am not just talking about level of returns but also the volatility of returns.
What if I need or may need the funds before 3 years?
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. 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 to 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 the highest tax bracket, your tax liability will be Rs 4,445.
Contrast this with Fixed Deposit
Let’s assume 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 case of fixed deposits, your tax liability will be Rs 24,000.
TDS and penalty of premature withdrawal will further tilt the balance in favour of debt mutual funds.
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 in a week or you may not need 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.
Do note you need to pick up the right variant of debt mutual fund too. Not all debt mutual fund offer FD like returns.
Point to Note
I have conveniently chosen an example to demonstrate the debt mutual funds are better. Therefore, you must not focus on the information shared in this post alone.
To be honest, bank fixed deposits have a few advantages over debt mutual funds too. The biggest is that FDs are so easy to understand. 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. This I can say based on my experience when my clients keep pushing me to recommend debt funds that have given good returns in the recent past.
You must read this post along with my earlier post on Bank Fixed Deposits vs Debt Mutual Funds before arrive at a decision. If you still cannot make up your mind, seek professional help from a SEBI Registered Investment Adviser.
I am a SEBI Registered Investment Adviser (RIA) and may have vested interest in asking you to seek services of a SEBI RIA.