Why Debt Funds are Better than Fixed Deposits?

The declining interest rate regime and the excessive liquidity caused by last year’s demonetization have forced banks to reduce their FD interest rates to historic lows. This, in turn, is forcing many retail investors to turn towards smarter investment alternatives like debt mutual funds.

Investment in debt mutual funds is a much better option than parking your money in bank FDs. Let us look at major reasons for this.

  1. Returns on Investment

After demonetization, many banks lower the FD rates due to excessive liquidity. State Bank of India (SBI), for example, currently offers 6.9 % for 1-year deposits, compared to 8% in 2015. For a 3 year deposit, it is even lower at 6.60%.

Debt funds have historically given returns in the range of 7-9% per annum.

As the returns of debt funds demonstrate, you can beat the banks by investing in debt funds. Debt fund investors assume both credit risk and interest rate risk and are hence compensated by higher returns.

  1. Taxation

The big difference between these two low-risk investment instruments is that of taxation.

In case of Fixed Deposits (FD)

The interest earned from FDs is added to your annual income for taxation purposes. Hence, the tax rate on interest earned from FDs will depend on your income tax slab, i.e. 5 %, 20 % or 30 % on the interest received.

For example, if your annual income, after including interest earned from your FDs, falls within the 30% tax bracket, the interest component will attract 30% income tax. Since many investors are in the top tax bracket, this takes away a large chunk of their returns.

In case of Debt Funds

Taxes upon debt mutual funds are of two types depending upon the period for which they are held. These two types are:

Short-term Capital Gain Tax: This is applicable to debt mutual funds held for a period of 36 months or less i.e. anything less than 3 years. In short-term capital gain tax, tax on funds is calculated as per income tax slab of the individual, i.e. 5%, 20% or 30% on the amount of gain.

Long-term Capital Gain tax: This is applicable to debt mutual funds held for a period of 36 months or more i.e. anything for more than 3 years. In long-term capital gain tax, tax on funds is calculated at the rate of 20 % with cost indexation on the amount of gain.

For example: 

Particulars Fixed Deposits Debt Funds
Invested Sum ₹ 10 lakhs ₹ 10 lakhs
Return Rate 10% 10%
Lock-in Period 5 year 5 year
Fund worth at the end of tenure ₹ 15,00,000 ₹ 15,00,000
Inflation per year 8% 8%
Indexed Investment Sum  – ₹ 14,00,000
Taxed Amount ₹ 5,00,000 ₹ 1,00,000
Tax to be paid ₹ 1,50,000 ₹ 20,000
Possible returns after tax ₹ 3,50,000 ₹ 4,80,000

Thus, even if a bank FD and a debt fund generate the same rate of return, the debt fund will still generate a higher post-tax return, provided you come under 20% or 30% tax bracket and your investment horizon is more than 3 years.

Tax Deducted at Source (TDS)

Apart from the above mention taxation, banks also deduct TDS on interest income from fixed deposits. It was introduced to collect tax at the source from where an individual’s income is generated.

As per the Income Tax Act, any company or person making a payment is required to deduct tax at source if the payment exceeds certain threshold limits. TDS has to be deducted at the rates prescribed by the tax department.

As a resident Indian, there will be no TDS when you sell/redeem your debt fund units. You are required to show the income and pay taxes, if any when you file your returns.

  1. Liquidity

Turning to liquidity, open-ended debt funds proceeds are credited within a period of 2-3 working days depending on factors such as whether an Electronic Clearing Services (ECS) mandate is registered. FDs are also typically available at 1-2 day’s notice, but usually, carry a penalty if they are redeemed before the maturity date.

Banks penalize premature withdrawal of FDs by paying a lower interest rate than the original booked interest rate. Premature withdrawal is however not allowed in tax saving fixed deposits as they have a lock-in period of 5 years.

Most banks currently deduct 1% from the original booked rate or 1% from the original card rate applicable for the period for which the FD has been in force, whichever is lower. These may adversely impact your FD’s effective rate of return in case of pre-mature withdrawal during emergencies.

Debt mutual funds, other than Fixed Maturity Plans, do not restrict redemption. However, many funds charge exit loads, ranging from 0.25–1% of the redeemed amount, if they are redeemed within a pre-specified period. Such periods can range anywhere from 15 days to 6 months.

Ultra short-term and many short-term funds do not charge exit loads. Such debt funds will suit best to park your emergency fund.

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