Invest in debt funds, against fixed deposits, for better returns

Investors usually have many queries on taxation of debt funds and tend to compare them with tax liabilities on earnings from bank fixed deposits (FDs). Gains from sale/redemption of debt funds are considered capital gains while interest income from FDs is considered as income and clubbed with the salary.

At present, short-term capital gains are taxed at a higher rate as compared to long-term capital gains (gain on investments for more than one year). There are indexation benefits on long-term capital gains if the holding period is more than one year to adjust for inflation.

Long-term capital gains from debt funds are taxed at 10 per cent without indexation and at 20 per cent with indexation. Short-term capital gains tax is deducted as per your income tax slab.

The Income Tax department releases a cost inflation index in the month of May every year for the previous financial year. This inflation data can be used to calculate the applicable tax rate. These rules may change after the new Direct Taxes Code is implemented from April 1, 2012.

In case of FDs, it doesn't make a difference whether the tenure is less than a year or more than a year.

One needs to evaluate one's investment horizon, risk appetite and liquidity requirements before deciding between fixed deposits and debt funds.

The tax payable on FDs and debt funds differs depending on which tax bracket you are in. Those in the highest tax bracket (income taxed at 30 per cent) can save tax substantially in the dividend option of liquid/ultra short-term debt schemes if their investment horizon is less than one year.

These debt funds are among the safest with a low interest rate and credit risk. Investing in the growth option will be similar to putting money in FDs from the tax point of view.

For others (in the 10 per cent and 20 per cent tax bracket), tax liabilities may not differ much, but in terms of convenience and flexibility, liquid and ultra short-term schemes score higher than FDs, as they can be redeemed anytime.

Close-ended schemes such as fixed maturity plans are similar to FDs in that they have a fixed tenure and carry a low interest rate risk as money from these funds is invested in debt securities with tenure similar to that of the scheme. In case of FDs, running around for tax deducted at source (TDS) certificates towards the end of the year can be a major hassle. If the investment horizon is more than a year, debt schemes of mutual funds score over FDs.

However, it would not be fair to compare longer duration debt schemes such as gilt funds and income funds with FDs as both are for separate needs. Gilt funds and income funds can generate double-digit returns when interest rates are falling, whereas FD rates move with a lag and are sticky over longer time horizons.

Hence, one needs to evaluate one's investment horizon, risk appetite and liquidity requirements before deciding between FDs and debt funds. One also needs to understand that returns from debt funds mirror interest rates in the economy on a daily basis whereas FD rates typically react with a lag. Over the long term, debt funds can generate better returns than FDs if invested at the right time.

Bexy Kuriakose
Head, Fixed Income L&T Mutual Fund