In India, with a stock market history going over 140 years it is a stark reality that less than 5% of the population invests in Equities. In our country, Debt continues to remain as one of the most preferred investment vehicles when planning for most financial goals. The Salaried class in variably have EPF as part of their Debt portfolio – some have Debt exposure due to NPS as well. In addition to these a big part of the savings in Indian households is invested in Debt – and undoubtedly Fixed Deposits corner a bulk of those investments.
A lot has been written on how FDs continue to be tax inefficient. They indeed are. For FDs one has the option to accrue the interest and pay tax at redemption or pay the accrued tax amount in each financial year (even without the actual interest cashflow -accrual basis). All FDs operated across financial years must have the same tax payment basis. And one cannot keep changing this across financial years.
For the purposes of this article the interest amount earned out of investments made in FDs is assumed to be added to one’s income each financial year and taxed as per their individual tax slab. The taxation on Income derived from Debt Funds can be deferred until redemption. If the Debt fund is held for more than 3 years the income earned can either be taxed at 10% without indexation or at 20% considering indexation. This is where Debt funds start to score over FDs. And the differences can be significant.
This write-up attempts to explain the ‘Effective yield on a FD/Effective yield on a Debt Fund’ that may be expected. It is reasonable to expect the CII will increase between 5% and 6% each year over the next decade or so if not more. The sample calculations have assumed CII of 5.5%. You can modify this to run various scenarios.
Let us assume the long term return for both FDs and Debt Funds is 8%. The CII increase equivalent rate is not taxed at all for holding Debt funds over 3 years. A back of the envelope (crude) calculation shows that incremental return (8% minus 5.5% = 2.5%) will be taxed at 20% which means one will lose 0.5% (20% tax on 2.5%) in returns in a Debt fund. Here is a more accurate calculator to compare Effective yields on FD vs Debt Funds.
As the tax slabs moves from 10% to 30% the effective yield shows a difference of as much as 2% higher for investing in Debt funds. This can result in a significant change in the corpus as the calculator shows.
While returns in a FD are near guaranteed (assuming one does not have concentration risk with a particular bank) the returns in a Debt fund can undergo fluctuations. Exposure to bad debt in the scheme can likely dent a part of the principal itself. This risk is inherent in a market linked scheme.
Debt Funds on the other hand allow partial withdrawals (as many units as you want) and as we saw here, are quite tax efficient leading to a much larger final corpus versus FDs. The Debt funds yielding these level of returns can give even the Tax Free Bonds a run for its money without the money necessarily being locked like in the case of the latter.
Download: Effective yields on FD vs Debt Funds