For most of us, our search for debt investments begins and ends at bank fixed deposits. When we have idle money in our bank, we invest the excess amount in fixed deposits. Bank fixed deposits are easy to understand. You simply need to walk into the nearest bank branch to invest. Moreover, with net banking becoming more and more popular, opening a fixed deposit is merely a click away for a number of us.
The FD returns are fixed and guaranteed. You don’t really need to worry about whether the banks can default. You believe that the Reserve Bank of India, the banking regulator, will take pro-active steps or in the worst case, the Government will come to your rescue.
Hence, it is no surprise that a number of investors don’t look beyond fixed deposits for their debt investments.
For some of us, debt mutual funds present a credible alternative to bank fixed deposits. Some argue, and correctly so, that the debt mutual funds are more tax-efficient than fixed deposits, especially for those in the higher income tax brackets. However, the returns from debt mutual funds are not fixed. Debt mutual funds face credit risk and interest rate risk and thus your money might be at risk.
In this post, I will compare the tax treatment of fixed deposits and debt mutual funds with the help of illustrations. I will compare fixed deposits and debt MF schemes on a few other parameters too.
Please understand I am referring to only bank fixed deposits. I advise readers to stay away from corporate fixed deposits and fixed deposits from co-operative banks.
Tax Treatment of Fixed Deposits and Debt Mutual Funds
This is an area where debt mutual funds score over fixed deposits.
The interest on fixed deposits is taxed at your marginal income tax rate. For example, if you make a fixed deposit of Rs 1 lac at 8% for 5 years, you will earn Rs 8,000 as annual interest.
You will have to pay tax on this interest income at your marginal income tax rate. If you fall in the highest income tax bracket, you will have to pay an income tax of Rs 2,400 on this income (30% of Rs 8,000). I have ignored surcharge and cess.
On the other hand, in case of debt mutual funds, the tax liability arises only at the time of sale of mutual fund units. So, if you purchase debt MF units today, you won’t have to pay any tax till such time you sell those units. It does not matter how long you hold those units.
If holding period for debt mutual fund units (at the time of sale) is less than or equal to 3 years, the resulting capital gains shall be treated as short term capital gains and taxed at the marginal income tax rate (income tax slab). The same treatment a debt mutual fund would get.
However, if the holding period is greater than 3 years, the resulting capital gains shall be treated as long term capital gains and taxed at 20% after accounting for indexation. There is a difference in how NRIs get taxed on their debt mutual fund investments. For more on NRI mutual fund taxation, please refer to this post.
Tax Deduction at Source (TDS) for Bank Fixed Deposits
A bank is required to deduct TDS (Tax deducted at source) if the interest paid during the financial year exceeds Rs 10,000 across all its branches. TDS is the tax deducted upfront by the bank (from the interest) and deposited with the Government.
So, if your annual interest from fixed deposits (from a particular bank) is Rs 8,000, there is no TDS applicable. However, if the annual interest is Rs 13,000, the bank will deduct TDS at 10% i.e. Rs 1,300. I have not considered cess and surcharge.
If you have furnished PAN with the bank, TDS will be deducted at 10%. Otherwise, the bank will deduct TDS at 20%. Please understand TDS has no relation to your marginal income tax rate (income tax slab).
Do note your income tax liability is not over if the bank has deducted TDS from your interest income. If TDS has been deducted at 10% and you fall in a higher income tax bracket, you need to pay excess tax as advance tax or while filing your income tax return. Similarly, if excess TDS has been deducted, you can claim a refund while filing IT return.
There is an interesting aspect about TDS. The banks pay interest on the balance net of TDS. Therefore, TDS reduces the effect of compounding, at least to some extent.
Let’s suppose you make an FD for Rs 10 lacs at 10% p.a. (compounded annually) for 5 years. The rate of TDS is 10%. The Impact of education cess has been considered in these examples.
If you were living in a tax-free world, you would receive Rs 16.1 lacs at the 5 years. You are not that lucky.
The lowest tax bracket has now been reduced from 10% to 5%. The tables below show calculations with 10% as the lowest rate.
However, you are fortunate enough to fall in the highest tax bracket. You pay tax on the interest income every year. You would expect the following (in absence of any tax deduction at source).
Now, let’s see how TDS impacts the calculations.
You will get only Rs 14.13 lacs (instead of Rs 14.21 lacs). This is because the presence of TDS has reduced the power of compounding. In this case, TDS has shaved off Rs. 8,566 off your returns.
TDS on sale of Debt Mutual Funds
There is no concept of TDS in case of debt mutual funds for resident Indians. The income tax liability arises only at the time of sale of such units.
In case of NRIs, TDS is deducted at 30% (34.608% after surcharge and cess) if the holding period is less than or equal to 3 three years. In case the holding period is greater than 3 years, TDS is deducted at 20% (23.072% after surcharge and cess) for unlisted funds and at 10% for listed funds (FMPs, close-ended funds). This is before surcharge and cess. NRIs are charged TDS at the maximum possible income tax rate. You can claim the excess tax deducted at the time of filing tax returns.
Illustration of Tax Benefits of Debt Mutual Funds
Let’s see the impact of taxation on returns from FD and debt mutual funds. I will consider investors from all 3 tax brackets.
Let’s assume debt fund also returns 10% p.a. over 2 years and 5 years. Do note the return of 10% is neither guaranteed nor fixed. The returns are market-linked.
You can see the difference is small. The difference is only to TDS on Bank fixed deposit. If the amount were less such that TDS was not applicable, then there would have been no difference between the net realization from fixed deposits and debt mutual funds.
But the real difference comes up when you are investing for more than 3 years. In that case, indexation benefits come into picture.
You can see the difference in net realization is huge in this case.
Points to Note
- Historical data for cost of inflation index has been used for the illustration. The levels of inflation may be lower in the future. In that case, the tax advantage for debt funds will automatically shrink. This has been the case in recent times (FY2019). The increase in cost inflation index has been quite low.
- The return for FD and debt fund has been assumed to be same. The return on FD is known at the time of investment. Returns of debt funds are market linked.
- Because of the tax benefits, it is quite possible that debt funds give better post tax returns despite offering lower pre-tax returns. For instance, if the return of debt funds over 5 years was only 9% p.a. while it was 10% per annum for fixed deposits, you will end up with Rs 14.13 lacs in case of fixed deposit whereas you will have Rs 15.34 lacs in case of debt funds.
Should you invest in Bank Fixed Deposits or Debt Mutual Funds?
Fixed Deposits cannot offer any capital gains. Debt funds (especially) offer you the prospect of significant capital gains. However, in bad times, you can face capital losses too.
If you are investing for the short term (less than 3 years), it hardly makes any difference at least from the tax standpoint.
Bank Fixed Deposits are easy to understand. Not everyone may be comfortable with debt mutual funds.
If you want to invest in debt instruments for up to 3 years, go for bank fixed deposits. Do consider certain practical issues such as penalty on premature withdrawal.
You open an FD for 2 years. However, you happen to need the money after just 1 year. If you break your FD prematurely, banks can charge a small penalty and also offer interest rate applicable for 1-year deposit (and not 2-year deposit).
Debt funds do not have such issues. You can take money out at any time. However, there might be exit load in some funds. If you are considering debt funds, do consider this aspect in mind.
If you want to invest for longer term (greater than 3 years), opt for debt mutual funds. Debt mutual funds are more tax-efficient than fixed deposits if the investment horizon is more than 3 years. Indexation benefits will come into play and boost your post-tax returns.
However, do remember even though debt mutual funds can offer you better post-tax returns, there is no guarantee of returns and there is risk involved. The choice of correct debt mutual fund is extremely important. You must be aware of the risk.
As mentioned in this post, I prefer debt mutual funds that have low interest rate sensitivity (low duration) and that invest in high credit quality debt securities.