Why bank FD interest rates can’t match debt mutual fund returns
Indian investors just can’t have enough of fixed deposits. According to a Crisil report, nearly Rs.170 lakh crore is lying in bank deposits across the country, which is more than the Rs.135 lakh crore combined investments in mutual funds, life insurance, retirement schemes and alternative investment funds. The study notes that though the share of bank deposits in total savings has come down, they still account for the largest slice of the household savings pie ( see graphic).The gargantuan amount lying in bank deposits is set to grow bigger. Banks have raised their deposit rates following the hike in the repo rate by the RBI. SBI has increased its deposit rates by up to 65 basis points and HDFC Bank by up to 75 basis points. Many smaller banks have also raised rates and other major banks are likely to follow suit.
However, before you pour your money into a fixed deposit, keep in mind that the interest earned on these deposits will be taxed at the normal rate applicable to you. In the 30% tax bracket, the 7% interest earned on the fixed deposit will get reduced to less than 5%.
Lower tax rate, no TDS
For investors, a better option is to go for debt funds. The gains from these funds are also taxable, but at different rates. If held for less than three years, the gains will be taxed at the same rate as the interest from bank deposits. But if you remain invested for more than three years, the gains from debt funds will be treated as long-term capital gains and will be taxed at 20% after indexation. Indexation takes into account the consumer inflation during the holding period and accordingly raises the purchase price of the asset to adjust for inflation.
Let’s assume you invested Rs.1 lakh in a debt fund three years ago and earned 7.5% compounded returns while the cost inflation index rose 15% in three years. The purchase price of the asset will be revised upwards to Rs.1.15 lakh (see graphic), which will reduce the gains and the tax on it. But interest earned on fixed deposits will not get any indexation benefit. Experts say high inflation is here to stay for some time, which means indexation can bring down the effective tax significantly.
Given that the prevailing yield to maturity of most debt funds is roughly 7-7.5%, the pre-tax returns from debt funds will not be any different from bank deposits. But it seems unlikely that interest rates will go higher from here. If interest rates go down, debt funds could give higher returns. The longer you hold a debt fund, the bigger is the indexation benefit.
This is why savvy investors time their investments to be able to get the maximum benefit from indexation. What’s more, the gains from a debt fund can be set off against short-term and long-term capital losses you may have made in other investments. There is also no TDS in debt funds. In fixed deposits, if your interest income exceeds Rs.40,000 a year, the bank will deduct 10% from this income. A taxpayer who is not liable to pay tax will have to submit either Form 15H or 15G to escape TDS.
More liquid than deposits
Debt funds are very liquid—you can withdraw your investments at any time and the money is in your bank account the next day. Some fixed deposits can be prematurely withdrawn, but you get a lower rate of interest. Also, when you prematurely close a fixed deposit, the entire amount gets withdrawn. But debt funds allow partial withdrawals, without breaking the entire investment.
Also, in some cases, the procedure for breaking a fixed deposit requires more paperwork than a click of a mouse. Another key advantage is the seamless shift from a debt fund to any scheme of the same fund house. Investors can also make periodic withdrawals, a facility that is particularly useful for retirees who want a steady income every month. The amount of the withdrawal can be changed whenever required.
This story originally appeared on: India Times - Author:Faqs of Insurances
