Debt funds vs Bank FDs: Which is the most tax-efficient investment?

Fixed deposits and debt mutual funds are among the most popular assets for risk-free investors. In spite of rising interest rates, fixed deposits have proven to be a reliable option for Indian retail investors, whereas debt funds are mutual funds that invest in debt securities. Debt funds have generally shown to deliver better-annualised returns than FDs, although bank FDs have a lower risk profile thanks to DICGC coverage. Risks associated with debt mutual funds include credit risk, interest rate risk, inflation risk, and reinvestment risk, whereas risks associated with fixed deposits include liquidity risk, default risk, and inflation risk. Although the two investment categories are mostly equivalent in terms of risk and returns, there are notable tax differences between debt funds and fixed deposits.

Tax treatment on fixed deposits and debt mutual funds

Dr. Suresh Surana, Founder, RSM India said “The taxation of debt mutual funds depends upon the period of holding of such funds. In accordance with section 2(42A) of the Income Tax Act, 1961 (hereinafter referred to as ‘the IT Act’), Debt oriented mutual funds held for up to 36 months (i.e. 3 years) are categorized as short-term capital gains and taxed as per the marginal slab rates applicable to an investor. On the other hand, units held for more than 36 months are long-term capital gains taxed @ 20% u/s 112 of the IT Act after availing the benefit of indexation. Further, any dividend derived from debt mutual fund is taxed as per the marginal slab rates applicable to the investor.”

He further said that “One earns Interest Income from FD’s and the same is taxed at Marginal Income Tax slab rates. However, no tax is levied on the maturity proceeds of a Bank FD, however, the bank would deduct TDS at 10%, if the interest amount paid to a resident individual exceeds Rs. 40,000 (Rs. 50,000 in case of senior citizen). The tax-efficient option for any investor would depend upon various factors such as the return derived from the investment, applicable tax bracket, nature and time period of holding (for instance, cost indexation benefit available in case of long-term debt mutual funds), FD interest deduction upto Rs. 50,000 is available u/s 80TTB for senior citizen, etc.”

Key differences between bank FDs and debt mutual funds

Mr. Sandeep Bagla,CEO, TRUST MF said “Liquid/Debt Funds & bank FDs can both be used to park short-term surpluses and earn moderate returns with low risk.

1. While securities in a Liquid Fund are subject to daily mark-to-market, FDs provide returns without volatility.

2. Most debt funds are open-ended and do not levy any exit load. In case of FDs, there is a penalty for early withdrawal through the term of the deposit.

3. In case interest rates soften, liquid funds can deliver returns higher than the portfolio yield, and vice versa. FD rate of return stays the same throughout its tenure.

4. In debt schemes, if an investor remains invested for 3 years or more, the effective tax rate is 20% with indexation benefits. In Bank FDs, an investor has to pay tax at the marginal rate which could be as high as 30-40%

5. Bank FDs are unsecured, whereas debt funds are secured by the securities they hold. Debt Funds could be preferred over FDs, as debt funds are secured, offer better liquidity, potentially higher returns than portfolio yield and are far more tax efficient.”

Return comparison between bank FDs and debt mutual funds

Nitin Rao,Head Products and Proposition, Epsilon Money Mart said “When it comes to fixed deposits, we Indians have a long association with it. Barring Real Estate, it finds a big allocation in all Indian portfolios. Debt funds are the closest which comes to FDs in terms of risk. They have slightly better returns ranging from 7-9% as compared to 6-8% in case of FDs. Other benefits include higher liquidity and even SIP routes are allowed. Taxation is where debt funds hit it out of the park. Firstly over a long-term period, FDs are taxed as per the tax slab while Debt fund is taxed at 20%. Also, they carry indexation benefits, meaning tax payments will be done after adjusting inflation.”

Where you should invest?

Mr. Ajay Lakhotia, Co-founder, StockGro said “Debt funds outrank FDs in a constantly evolving macroeconomic scenario. They provide marginally higher returns with similar risk levels and offer better benefits for investors in higher tax slabs. Long-term debt investments come with indexation benefits at a 20% tax rate. And features like dividends, early withdrawals & SIPs translate to better inflation protection. Sized over $2 trillion, the Indian bond market is among Asia’s largest. It is an ocean of opportunity and many risk-averse players like banks, insurance companies & FIIs dominate this space. It’s time for retail investors to start leveraging it too.”

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint.

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