Why Debt Funds are Better Than Fixed Deposits
Fixed Deposits (FDs) have been the go-to investment option in India for many generations. This popularity is mostly due to the guaranteed returns and the low risk associated with FD investments. So deep is the love for FDs that they are used for every goal – be it short-term or long-term. And while FDs can be a good option for short-term investments, there is a smarter way to invest in Debt for the long term. The solution is Debt Funds.
While Debt Funds might not offer guaranteed returns, they do outscore FDs on one of the most crucial factors – taxation.
In this blog, we will discuss how debt mutual funds are better than fixed deposits in terms of return, risk, liquidity, dividends, etc. And how FD interest earnings and Debt Fund returns are taxed.
Taxation Rules of Fixed Deposits Vs Debt Mutual Funds
Although Fixed Deposits and Debt Mutual Funds are debt instruments, there are quite a few differences in how they are taxed. The first and perhaps the most fundamental difference is when the returns are taxed.
In the case of Fixed Deposits, the entire interest earned is subject to tax for the applicable financial year. In fact, all the interest earned from FDs in a financial year has to be declared in your Income Tax Return under the head “Income from Other Sources”. On the other hand, Debt Fund returns are taxed only when they are realized, i.e., when the investments are redeemed. This is called deferred tax treatment.
Apart from this fundamental difference, for the holding periods of less than 3 years, there is no difference between how FD and Debt Fund taxation works. The returns are added to your income, and you are taxed as per your Income Tax Slab rate.
However, for the holding period of more than 3 years, while FD taxation remains the same, the Debt Funds taxation rules change. That is because Debt Fund gains are classified as Capital Gains and the rules for Capital Gains are different for different holding periods.
If you redeem your Debt Fund investments after holding them for at least 3 years, the gains made are classified as Long-Term Capital Gains or LTCG. As per current rules, LTCG are taxed at 20% after indexation.
There are two words here – 20% and indexation. And these two things along with deferred tax treatment make Debt Funds far more tax-efficient than FDs. While the 20% rate is fairly clear to understand, indexation is a bit complicated. However, it is perhaps the bigger reason for the tax efficiency of debt funds. So, let’s look at it a bit deeper.
Difference Between FD and Debt Mutual
Fixed deposit is an instrument wherein you invest an amount with financial institutions like banks and NBFCs for a fixed period. In return, you receive interest. You can invest in the fixed deposit for a minimum of 7 days and a maximum of up to 10 years.
Debt mutual funds are a type of mutual fund managed by an Asset Management Company (AMC). When you invest in debt funds, your money is invested in debt papers of private companies, PSUs, government bonds, etc. In the case of debt mutual funds, you are not promised a certain amount on maturity. In fact, for most debt funds, there are no maturity dates. You can enter and exit at any time. And well-managed debt funds have typically delivered better returns than FDs.
How Indexation Helps Reduce Tax Liability of Debt Funds
Indexation is the process using which you adjust the purchase price of an asset to account for the increase in inflation between the time you bought the asset and sold it. In case you are confused, don’t worry, we will try to simplify the concept with an example.
Suppose you bought a Spiderman comic book 5 years back for Rs. 500, but you had forgotten all about it. Recently you were going through some old things, and you found the old issue still in its original packaging which had never been opened. After a quick online search, you find that a new edition of the same comic would cost you Rs. 1500.
But since the comic book you have is older, and in mint condition, some collectors are willing to pay Rs. 2500 for your comic book. So, if you were to sell it, your profit will be = 2500 (your selling price) – 500 (your purchase price) = Rs. 2000.
But, due to inflation, the current market price of the comic book has increased to Rs. 1500. So, for the purpose of taxation, the government allows you to adjust the purchase price of your comic book to account for inflation. So, your taxable profit from the sale of your comic book will be = 2500 (your selling price) – 1500 (current purchase price) = Rs. 1000.
While indexation calculations of Debt Fund Investment returns are much more complicated than the simple example provided above, it gives you an idea.
As a tool to preserve wealth, the fixed deposit makes perfect sense considering the key benefits of guaranteed returns and minimal risk.
However, if you are planning to book an FD for tenures exceeding 3 years, it might be a good idea to rethink your strategy and invest in Debt Mutual Funds instead. At the very least, such long-term Debt investments will significantly reduce your tax liability especially if you are in the highest 30% tax bracket. At best you will earn higher returns on your investment than what an FD can offer while still ensuring that you pay less tax on your investment returns.