My 9% Bank FD is up for renewal. Can I continue earning the same returns? Yes. - fisdom

My 9% Bank FD is up for renewal. Can I continue earning the same returns? Yes.

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While your total CTC may be impressive, you would always look at the net salary you receive in hand at the end of every month, right?

Similarly, the gross interest rates were quite impressive at ~9% towards the end of 2013, but what really matters is the returns you receive in hand. For a depositor with a personal tax rate of 20%, the effective returns were ~7.1%.

For a period where retail inflation stood at ~11%, returns of 7% is essentially a real loss of 4% on the amounts deposited into a bank fixed deposit. In fact, even for a tax-exempt person, the real returns were negative – the cost of living increased higher than what your fixed deposit would have generated.

With continuing lackluster in bank fixed deposits, investors are seeking better products like debt mutual funds for superior returns.

So, what’s a debt mutual fund?

A debt mutual fund is a product where the Asset Management Company, on behalf of the investors, invest into debt instruments like corporate bonds/debentures, sovereign bonds, government securities and other similar instruments. Debt funds usually seek appreciation through coupons (interest payments) and capital appreciation because of changes in interest rates.

Debt mutual funds offer higher returns

Today, we are sitting on low inflation which is good news. But, does this make bank fixed deposits more attractive? Maybe not.
Bank deposit rates usually are in line with inflation and inflation expectation. The low inflation rate reflects on the deposit rates as well.

Deposit rates have tanked to ~7% range. Also, while debt mutual funds continue to perform well, a conservative ~8.5% can be well expected.

The tax-angle makes debt mutual funds all the more attractive

Along with higher returns, the tax-efficiency angle adds a lot of sheen to debt mutual funds as a product.

How would it feel if your friend takes a big bite off your ice-cream even before the ice-cream man hands it over to you? Feels bad, right?

Now, this is exactly what happens to the interest you receive from your fixed deposit. Even before you receive the interest on your deposit, you have to pay your tax on the amount you expect to receive – tax on accrual basis. To make things worse, there is a standard TDS (Tax Deduction at Source) of ~10% which gets deducted systematically, even before you file your taxes.
Unlike bank FDs, the taxes on debt funds are pretty fair – you pay tax only on the gains you redeem. Also, while the gains are taxed as per your personal tax rate if you redeem up to 3 years; it also offers an indexation benefit (inflation-adjustment) on the 20% tax if you redeem your gains after 3 years.

What’s an indexation benefit?

Over a period, one will have to pay more to buy the same product because of inflation. Indexation ensures that your tax computation does not include the increase in value due to inflation, rather just the real gains beyond inflation

Here’s a comparative illustration of how does indexation benefit an investor.

With Indexation Without Indexation
A Invested Amount  1,000,000  1,000,001
B Value after 3 years  1,242,297  1,242,298
(A-B) Gain redeemed after 3 years  242,297  242,297
C Increase in investment value due to inflation @ 6.5% p.a.  207,950 NA
(A-C) Real gains (excluding inflation effect)  34,347 NA
Tax @ 20%  6,869  48,459
  (20% of ‘C’) (20% of ‘A-B’)
Net Earnings 12,35,428 11,93,838

 

The indexation benefit saves you from paying higher tax without considering your burden of increased costs. On a larger landscape, tax-efficiency offered by debt mutual funds just start making much more sense.

The below is a tax-analysis illustration which offers an interesting insight into the real effect of tax efficiency. While we can expect returns on debt funds in ~8.5% range and bank FD ~7%, we will assume same returns of 7.5% just to analyze the tax impact.

 

 

Debt MF Bank FD Bank FD Bank FD
Returns 7.5% 7.5% 7.5% 7.5%
Personal Tax Rate Any 10.3% 20.6% 30.9%
Invested Amount  1,000,000  1,000,000  1,000,000  1,000,000
As on end of Year 1
Returns earned  75,000  75,000  75,000  75,000
Tax on accrual 0  (7,725)  (15,450)  (23,175)
As on end of Year 2
Returns earned  155,625  80,625  80,625  80,625
Tax on accrual 0  (8,304)  (16,609)  (24,913)
As on end of Year 3
Returns earned  242,297  242,297  242,297  242,297
Tax on gains redeemed  (6,869)  (8,927)  (17,854)  (26,782)
Net Earnings  235,427  217,340  192,384  167,427
Avoidable Loss (INR)  18,087  43,044  68,000
*Assuming inflation at 6.5% p.a. for indexation computation | Personal Tax Rate inclusive of cess

 

Debt mutual funds offer higher & cost-efficient liquidity

Debt mutual funds can be redeemed whenever you wish without any penalty costs. Bank fixed deposits usually charge up to 1% of the amount on premature redemption of funds.

Safety is relative and debt mutual funds are relatively safe

While choosing a debt mutual fund, one has to be careful about the credit quality of the debt instruments invested in. Sovereign and AAA-rated securities are as safe as it gets followed by AA, A, BBB and so on in descending order of quality. Being invested in AAA-rated & sovereign securities are relatively the safest.

Fun fact: Bank fixed deposits are insured only to the extent of Rs.1 lakh. This means that if your bank undergoes a crisis and shuts shop, you are indemnified only to the extent of Rs.1 lakh.

Bottom-line:

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