How a low growth in CII can affect your post-tax returns and investment choices?

Long Term Capital gains on sale on debt mutual fund units are taxed at 20% after indexation. That is primarily the reason why many investors choose to invest money in debt mutual funds if the investment horizon is more than 3 years. I am talking about money that you don’t want to invest in volatile assets such as equity.

While this is mostly correct, this may not always hold true.

Let’s consider an example.

Suppose you had deposited Rs 10 lacs in a cumulative fixed deposit at 8% p.a. The FD is for 3 years.

At the same time, you put Rs 10 lacs in a debt mutual fund. Let’s assume you earn a pre-tax return of 8% p.a. on your debt fund investment.

You made these investments on May 31, 2015. Your FD matured after 3 years. Let’s assume you redeemed your MF investments too after 3 years.

FD maturity value: Rs 12.59 lacs ( To keep matters simple, I ignore the impact of TDS, if any)

Debt Fund Maturity value: Rs 12.59 lacs

How much tax will you pay in the two cases?

In case of a fixed deposit, the interest income is taxed at your income tax slab rate.

Let’s assume you fall in 5% tax bracket. Even though 5% tax bracket was introduced only from FY2018, I am keeping it constant during the entire term.

For the three years, you would have paid a total tax of about Rs 13,000 on interest income.

On the sale of debt fund investment, you will have to pay capital gains tax at 20% after indexation.

CII level for FY2016 was 254.

CII level for FY2019 is 280.

Therefore, your indexed cost of purchase is Rs 10 lacs * 280/254 = Rs 11.06 lacs

Taxable capital gain = Rs 12.59 lacs – Rs 11.06 lacs = Rs 1.53 lacs

Total Tax liability = 20% * 1.53 lacs = Rs 30,598

You may have expected to pay lower tax in case of debt mutual funds since you held the units for more than 3 years.  To be honest, the first question that I ask my clients while advising them on debt investments is whether the horizon is more than 3 years or less than 3 years.

However, in this case, you are paying much lower tax in case of bank fixed deposit.

What happened?

There are two reasons for this.

1. The marginal tax rate assumed is 5%. If you were in 20% tax bracket, your tax liability in case of bank FD would have been 4X i.e. ~52,000
2. CII (Cost of inflation index) has not risen sharply. A higher rate of growth in CII would have brought down tax liability in case of debt fund investment.

What should you have chosen?

Well, taxation is just one part. There are many aspects where debt MFs and fixed deposits differ.

Let’s have a quick look.

Where Debt Mutual Funds score over Fixed Deposits?

Interest on fixed deposits is taxed at your slab rate. Even if you do not get the interest in hand, you have to pay tax on the interest income.

On the other hand, in case of debt mutual funds, the tax liability arises only at the time of sale. When you sell mutual fund units, the redeemed amount contains both your principal and capital gains. You get taxed only on the capital gains (and not on the principal amount). Therefore, your effective tax liability can be much lower in case of a debt mutual fund. I have discussed this aspect in detail in this post. Short-term gains are taxed at your slab rate while long-term capital gains are taxed at 20% after indexation.

Debt mutual funds offer greater flexibility since you can redeem anytime. On the other hand, if you break a fixed deposit prematurely, you will have to incur some penalty. Moreover, you can redeem your MF investment only partially. If you do not know when and how much will be needed, debt mutual funds clearly score over FDs.

There is an additional hit on returns due to TDS in case of fixed deposits (unless you are eligible and can provide  Form 15G/Form 15H to your bank). With TDS, there may be an additional pain of claiming tax refund if you fall in the 5% bracket. There is no TDS on sale of debt mutual funds unless you are an NRI.

Debt mutual funds can offer you the benefit of double indexation (if you plan smartly). No such benefit for fixed deposits.

So, many positives for debt mutual funds.

Where Fixed Deposit score over Debt Mutual Funds?

A fixed deposit is perhaps the simplest financial product to understand. On the other hand, debt mutual funds come in multiple variants and it is not difficult to select a wrong type of debt mutual fund. And there is risk in debt mutual funds too.

Once your total income breaches minimum exemption limit, there is no further relief in case of long term gains in debt mutual funds. You will have to pay long capital gains tax (20% after indexation). There is no relief under Section 80C to Section 80U for long-term capital gains tax.

In case of interest income from fixed deposits, you can still take benefit under Section 80C to Section 80U and reduce your total tax liability.

Moreover, if you are a senior citizen, the interest income of fixed deposit is exempt from tax to the extent of Rs. 50,000 per financial year under Section 80TTB. No such relief for debt fund investments.

Who is the winner?

As you can see, there can be no clear answer. The choice between a bank fixed deposit and a debt mutual fund will depend on the specifics of your case.

Purely from the tax perspective, a bank fixed deposit may be more beneficial for investors in 5% tax bracket. In addition, if you are a senior citizen, the case for a fixed deposit becomes even stronger.

However, for investors in 20% or 30%, a debt mutual fund is likely to be a better option. However, you need to select the right kind of debt fund too.

Can you take action basis this?

Clearly not.

It is difficult to predict how CII (Cost of inflation index) will grow over the next few years. At least, I don’t know how to forecast.

I have picked up a time frame to suit my argument. From index level of 254 in FY2016, the level is now 280 in FY2019, a growth of about 10% in 3 years. That is compounded growth of 3.3% p.a. Because of this, indexation could not lower tax liability significantly.

However, over the long term, there will be low inflation periods and there will be high inflation periods. For instance, from FY2010 to FY2013, the CII went up from 148 to 200, an increase of almost 35%, a compounded growth of about 10.5% p.a. With such levels of rise, you may have to report losses after applying indexation (good for you).

Even if we take growth in CII from FY2010 till FY2019, you have a health compounded growth of 7.3% over these 9 years. Indexation will still eat a good chunk of your capital gains and reduce your tax liability significantly.

So, what to do?

Be open.

Don’t be rigid about your preference. You may love fixed deposits. However, it is possible that for a particular case, debt MF may make for a better choice. Or it may be the other way round.

I prefer low duration and high credit quality debt funds for my debt investments. I get better flexibility and potentially benign tax treatment too. But I do acknowledge, that for some of us, a fixed deposit may be a better choice.