Debt Funds or Fixed Deposits?

Traditional Fixed Deposits are preferred over any market linked investments. This is mainly due to the security of investment and assured returns. Debt funds also come with a lot of benefits and are meant for risk averse investors who do not prefer to invest in equities. However, should one put aside some money to invest in Debt Funds? Let’s have a look at how Debt Funds compare with Fixed Deposits.

Returns – Fixed Deposits almost always have a fixed rate of interest that you will earn on your deposit. Whereas – Debt Funds do not come with the promise of assured returns.

Tax – The entire income from FDs is taxable at the slab rates applicable to you. However for Debts Funds – based on the change in the Budget of 2014 – Debts Funds are considered as Long Term Capital Assets when held for more than 36 months. Which means, if you hold them for more than 36 months, you can get the benefit of indexation of the cost and your gains shall be taxed at 20%.

Lets see that with an example – Suppose Vikas who is in a 30% tax bracket invests Rs 1,00,000 in a fixed deposit in Dec 2011. He holds the FD for 3 years and earns an interest of 9% each year. His total Interest Income shall be Rs 9000 in the first year, Rs 9810 in the second year, Rs 10693 in the third year. Totalling Rs 29502. On which he shall be liable to pay a tax @ 30% = 9116 (Rs8850 +265(3% cess)).  Net gain = Rs 1,29,502 – 9116 = Rs1,20,386

If Vikas invests Rs 1,00,000 in Dec 2011 in a debt fund that gives 9% interest. In this case the value of his investment after one year shall be Rs 1,09,000, Rs 1,18,810 at the end of second year and Rs 1,29,502 after 3 years. Cost shall be indexed and therefore Rs 1,00,000 *1024/785 = 1,30,445. This actually results in a capital loss for Vikas – although his returns % is the same as compared to Fixed Deposits. He doesn’t pay any tax on the gains!

TDS – Interest exceeding Rs 10,000 earned by you on Fixed Deposits is subjected to TDS by the bank every year – even though you may not have received any interest – TDS is deducted on accrual basis. No TDS is deducted on returns from Debt Funds. Though some debt funds may be subjected to an exit load in the range of 0.5% to 1%. Any tax applicable on a debt fund arises only on maturity and not during the time you hold the fund.

Final word – Debt funds when held for more than 3 years are more tax efficient and can give better returns that Fixed Deposits. Debt Funds must be purchased after full review of the fund house and the fund’s performance.

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