The hardest thing to understand in the world is income tax- Albert Einstein
Recently, I met an old friend. He is very sceptical about mutual funds and considers them risky. When I talked about debt oriented mutual funds who don’t have the same risk profile as equity funds, he was not convinced. While he agreed that debt mutual funds offer some flexibility, he was not convinced about its tax efficiency compared to fixed deposit. In this article, how despite having same tax treatment, debt mutual funds are far more tax efficient, flexible and versatile.
Understanding tax is difficult but rewarding. We don’t believe in tax evasion but avoiding paying tax by suitable tax planning is crucial for creating wealth. While choosing investments, wee don’t ignore the tax efficiency of the investments. Taxes should be avoided or deferred wherever possible. Using relevant examples, we show how debt mutual funds offer substantially higher post-tax return, even if we assume that pre-tax returns are the same as fixed deposit.
Most people in India have great faith in fixed deposit. From recurring deposit to deposits offered by companies, people like the surety of returns offered by these and have invested lot of money in these deposits. The taxation impact has been largely ignored in past. However, things are changing now. Now tax is being deducted at source from interest income. Furthermore, income tax authorities have all the TDS data on interest income. Even if you want the surety of returns that fixed deposits, it is worthwhile to examine if this is the most tax-efficient fixed income instrument (if you are paying taxes on interest income). In our examples, we have ignored minor surcharges etc for the sake of simplicity.
Debt mutual funds appear better from liquidity and taxation perspective
Effective tax rate is far lower for debt mutual fund, even for holding period of less than 3 years
After the change in taxation rules of debt mutual fund, there is a common view that taxation of debt funds for shorter holding period (less than 3 years) is the same as fixed deposit. While this is correct on headline basis, there is one crucial difference in how tax is calculated. In fixed deposit, tax is paid on the entire interest income whereas tax is paid only on the capital gain portion of debt mutual fund. Let us assume that a person has 20 lacs that he can invest in fixed deposit or a debt mutual fund. Further assume that the pre-tax return on fixed deposit as well as debt mutual is 10%. The investor will get interest income of 10% on 20 lacs investment every year. Now if he were to invest in the non-dividend paying debt mutual fund, he will not get dividend or interest income but value of his debt mutual fund holding will increase by 10 %. To get the same income, he will sell 2 lacs worth of mutual fund (so he will sell the mutual fund units worth 2 lacs). Let us how tax will be calculated in both these scenario:
The below example will further clarify this:
So, the key takeaways from this discussion are:
- Debt mutual funds are more tax efficient than fixed deposits across holding periods.
- When investing in debt mutual funds, investors should be aware about default risk and interest rate risk. Investors should look to mitigate default risk (risk of non-payment of debt obligation). This can be done by choosing debt mutual funds that invest only in government or quasi-government bonds.
- Investors should look to manage interest rate risk by investing in dynamic bond funds.
- Fixed deposits should be avoided if you are not in tax-exempted category.