Debt funds are extra tax efficient

It is a security vis-a-vis returns battle between bank fixed deposit and debt funds.

In the past few months, banks have been consistently increasing their rates of interest on special fixed deposit. And after the Reserve Bank of India’s Annual Monetary Policy, even the saving deposit rates are up at 4 %. For a six-month fixed deposit, you can easily get a rate of anywhere between 6 and 7 % annually.

However, experts feel if one is looking to invest for less than a year, debt funds could make a better choice. The reason: Liquid funds and ultra short-term funds are giving annualised returns of 8 %.

Financial advisors suggest retail investors opt for mutual fund schemes as they are more flexible and give higher post-tax returns. According to certified financial planner, Suresh Sadagopan, opt for fixed deposits only if you are comfortable being locked-in for the tenure as a premature exit can attract a penalty. If your main aim is to ensure liquidity, debt funds are preferable.

Mahendra Jajoo, executive director and chief investment officer (fixed income) at Pramerica Mutual Fund says though a fixed deposit gives you assured returns, you have to be locked in till the end of the tenure. “In case you break your deposit before it matures, you will have to pay a premature penalty (1-2 %).”

When investing in a debt fund, you will have to consider the interest rate risk and expense ratio of the fund. The higher the expense ratio, the lower is the investible amount and hence a lower maturity amount, adds Jajoo. In debt funds such as ultra short-term funds, you have the option of withdrawing whenever you want without paying an extra cost.

Take a liquid fund, for occurrence. It offers higher and more tax-efficient returns than your savings accounts. While you earn an annual interest of 4 % on your savings account, by investing in liquid funds you make 5.5 % on average. You can invest in these funds for as short as one day. No exit load is charged for any untimely withdrawal.

Liquid funds are flexible when it comes to investment periods, something bank fixed deposits will not allow.

“Fixed deposits guarantee return, which debt funds do not. But, they are more tax-efficient,” says Sumant Kathpalia, head – consumer banking, Indusind Bank.

For ultra short-term and short-term funds, the interest income will be added to the total income and taxed, as per the income tax slab. This is similar to tax on returns from short-term fixed deposits.

A better way to exploit debt funds would be to choose the dividend option. In this case, the fund house will deduct 14.16 % from the dividend it pays you. For the highest income tax bracket, this saving can be as high as 20 %.

Say, you had invested Rs 1 lakh in a six-month bank deposit and another Rs 1 lakh in an ultra short-term debt fund for the same period. The deposit would have given an annual return of 7 % and the fund 8.5 %.

Assuming you fall in the highest tax bracket, there will be a tax liability of Rs 1,081.50 on the deposit (post-tax returns = 2.4 %) and Rs 595 on the debt fund (dividend option), post-tax returns = 3.6 %.

Source: [Business-Standard]