How debt mutual funds are more tax efficient than bank fixed deposits (FDs)?

For conservative investors, fixed deposits and debt mutual funds are among the most prominent debt investments. Debt funds are the next lowest-risk alternative to FDs, but when it comes to liquidity and regular investment option debt mutual funds steals the show. Taxpayers are aware that short-term capital gains on debt fund investments held for under three years are subject to your tax slab rate, long-term capital gains on debt fund investments held for more than three years are subject to a 20% tax rate with indexation benefits, and gains on fixed deposit returns are subject to your tax slab rates. However, financial advisors claim that if investors are in a higher income tax bracket then debt funds are more tax-efficient for them than fixed deposits, let’s know-how.

Based on an interview with CA Manish P Hingar, Founder at Fintoo, the spokesperson said “Both Bank Fixed Deposits and Debt mutual funds are suitable for investors with low to moderate risk profiles but a wise choice has to be made between the two considering their liquidity, risks, return, and taxation. From a taxation perspective, Debt mutual funds are more tax efficient than bank fixed deposits. This is because the gains from debt mutual funds are taxed differently. Interest income earned from bank fixed deposits is taxed as per the individual’s tax slab, whereas the income from debt mutual funds is taxed based on short-term and long-term Capital Gains. If debt mutual funds are redeemed after holding it for more than 36 months then such long-term capital gain is taxed at 20% with indexation benefit. On the other hand, short-term capital gains are taxed at the individual’s tax slab if held for less than 36 months.”

“For Example, if you invest 1,00,000 in a debt mutual fund for 4 years that has generated a CAGR of 8%, your investment value after 4 years will be around 1,36,000 and your gain will be 36,000. Tax liability on selling the debt mutual funds after considering the benefit of indexation i.e. inflation adjustment will be 3,566. In case of investment in a fixed deposit of the same amount, earning a similar return and of the same tenure, one will have to pay a tax of 10,800 considering the investor falls in the 30% tax bracket. Having said that, the tax implications on bank FDs and Debt mutual funds would be the same in the case of investments held for less than 3 years. However, considering long-term capital gain taxation and the tax bracket of an individual, debt mutual funds are a better option for investors in the higher tax bracket,” said CA Manish P Hingar.

“Please note that based on risk and return comparison banks are considered almost risk-free as your investment is insured up to the extent of 5 lakhs and returns are also predetermined while in case of debt mutual funds returns are market linked and are subject to interest rate risk, default risk, and inflation risk,” said CA Manish P Hingar.

Based on an interview with Nitin Rao,Head Products and Proposition, Epsilon Money Mart, the spokesperson said “When it comes to taxation on fixed deposit and debt mutual funds, the later one holds an advantage over 3 year and above period. Interest earned from Fixed deposits is taxed as per the investors’ income slab rate However, no tax is levied on the maturity proceeds of a Bank FD. The bank will deduct TDS at 10% if the interest amount paid to a resident individual on FD exceeds Rs. 40,000 (Rs. 50,000 in the case of a senior citizen). In case of debt mutual fund, the taxation depends on the holding period, for the holding periods of less than 3 years, there is no difference between how FD and Debt Fund taxation works. But if you redeem your debt mutual fund after 3 years than the gains/profit are taxed at 20% after indexation. Indexation is the process of adjusting the value of investment in align with inflation to protect your capital gains against tax erosion.”

The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.

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