Debt Funds - The Tax Warrior against FDs

Fixed Deposits have long been associated with assured returns for most of our contemporary and previous generation population. A “tension free” return of 8-10% has meant the holistic investment planning for many of us. But this “tension free” return comes at a huge cost in the form of ensuing taxability. Below is an illustration how Taxes eat into our FD returns.

                                                             

Annual Interest on FD		10%	20%	30%
	8%	7.2%	6.4%	5.6%
	9%	8.1%	7.2%	6.3%
	10%	9.0%	8.0%	7.0%

* If you feel difference of 1-2% is nothing you might want to know about power of compounding

So as the above illustration shows, net return of FDs keeps on decreasing with rise in applicable tax bracket, making the ‘safe’ return of FDs even lower. There are two more points to take note of as far as taxation of FDs is concerned:

1.     One has to declare interest earned on FDs every financial year irrespective of investment or maturity date of the FD. E.g. you make an FD in Dec’12 for three year duration, so you are supposed to declare interest accumulated in the financial year 12-13, 13-14 and 14-15 separately in the respective financial year income tax return.

2.     Contrary to popular perception there is no tax free interest on FDs. Some people think that interest earned upto 10,000 in a financial year is tax free. But reality is that limit is for saving account interest only, not FDs.

So is there is any alternate which is as safe and more tax efficient ?

Yes there is and its known as Debt Funds.

Before exploring how Debt funds are more tax efficient than FDs, lets first explore what Debt funds are.

Banks offer FDs for raising money, in the same manner companies offer different Debt instruments like Commercial Papers, Debentures, etc to raise money for their capital needs. Following is the nature of these instruments –

• Rated by independent rating agencies like CRISIL etc for their creditworthiness
• Intermittent in nature – Unlike bank FDs they are not available for subscription continuously. Companies offer them only when they need capital for some specific or general working capital requirement.
• Rate of Return offered by these instruments depend on the ratings. So higher is the rating, lower is the rate of return

Debt funds function in below manner –

1. Mobilise money from retail investors like me and you
2. Invest the money thus collected in different debt instruments like the ones defined above, apart from government bonds , money market instruments etc.
3. Allocate ’Units’ to investors based on their quantum of investments
4. Payback money to investors when they redeem their investments

Now coming to taxation part, Debt funds score over FDs because you can use Inflation to pare down your returns for tax calculation. Instead of going into theory, lets try to understand it by an example -

*Capital Appreciation considered for Tax Calculation

Fixed Deposit = [(D) - (B)]

Debt funds = (D) - [(B) *[(Inflation Index during (D)/Inflation Index during (A)]

Inflation Index = A parameter based on ensuing inflation for respective financial year , declared for every financial year by government.

Redemption = Process of taking out investment

Capital appreciation = Amount considered for calculating tax

Returns After Tax = Returns realized after paying applicable tax

So as we can see from above example, even though a Debt fund’s returns were supposed to be lower than a FD, in reality it gave better returns because of lower taxation.

But above taxation is applicable only if investment is made for more than 3 years, otherwise it remains same as that of FD.

Wait for our next article to learn What are types of Debt funds and how to invest in them.

Inflation Index i.e. Cost of Inflation Index (CII) is as below for different financial years –

You might also like to read about my perspective about Financial Planning. And as always thanks for reading and if you like it shout out :) help your friends by connecting him/her to us via facebook or email : healthynivesh@gmail.com