Friday, May 19, 2017

Bank Fixed Deposits vs Debt Mutual Funds

For most of us, our search for debt investments begins and ends at bank fixed deposits. When we have idle money in our bank, we invest the excess amount in fixed deposits. Bank fixed deposits are easy to understand. You simply need to walk into nearest bank branch to invest. Moreover, with net banking becoming more and more popular, opening a fixed deposit is merely a click away for a number of us.
Returns are fixed and guaranteed. You don’t really need to worry about whether banks can default. You believe that Reserve Bank of India, the banking regulator, will take pro-active steps or in the worst case, the Government will come to your rescue.
Hence, it is no surprise that a number of investors don’t look beyond fixed deposits for their debt investments.
Of late, you would have read a lot about how debt mutual funds can present a credible alternative to bank fixed deposits. Some argue, and correctly so, that the debt mutual funds are more tax-efficient than fixed deposits. Others counter that the returns from debt mutual funds are not fixed, face credit risk and thus your money might be at risk.
In this post, I will compare tax treatment of fixed deposits and debt mutual funds with the help of illustrations. I will compare fixed deposits and debt MF schemes on a few other parameters too.
Please understand I am referring to only bank fixed deposits. I advise readers to stay away corporate fixed deposits and fixed deposits from small co-operative banks.

Tax Treatment of Fixed Deposits and Debt Mutual Funds

This is an area where debt mutual funds score over fixed deposits.
Interest on fixed deposits is taxed at your marginal income tax rate. For example, if you make a fixed deposit of Rs 1 lac at 8% for 5 years, you will earn Rs 8,000 as annual interest.
You will have to pay tax on this interest income at your marginal income tax rate. If you fall in the highest income tax bracket, you will have to pay income tax of Rs 2,400 on this income (30% of Rs 8,000). I have ignored surcharge and cess.
On the other hand, in case of debt mutual funds, the tax liability arises only at the time of sale of mutual fund units. So, if you purchase debt MF units today, you won’t have to pay any tax till such time you sell those units. It does not matter how long you hold those units.
If holding period for debt mutual fund units (at the time of sale)  is less than or equal to 3 years, the resulting capital gains shall be treated as short term capital gains and taxed at the marginal income tax rate (income tax slab).
However, if the holding period is greater than 3 years, the resulting capital gains shall be treated as long term capital gains and taxed at 20% after accounting for indexation.

Tax Deduction at Source (TDS) for Bank Fixed Deposits

A bank is required to deduct TDS (Tax deducted at source) if the interest paid during the financial year exceeds Rs 10,000 across all its branches. TDS is the tax deducted upfront by the bank (from the interest) and deposited with the Government.
So, if your annual interest from fixed deposits (from a particular bank) is Rs 8,000, there is no TDS applicable. However, if the annual interest is Rs 13,000, the bank will deduct TDS at 10% i.e. Rs 1,300. I have not considered cess and surcharge.
If you have furnished PAN with the bank, TDS will be deducted at 10%. Otherwise, the bank will deduct TDS at 20%. Please understand TDS has no relation to your marginal income tax rate (income tax slab).

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