Last Updated on December 18, 2021 at 10:47 pm
There are many articles on the web that talk about the difference in the way debt mutual funds and fixed deposits are taxed. Almost all of them (including the ones by self-proclaimed beacons of financial literacy) talk about post-tax returns typically over 3-5 year periods.
To my knowledge there is only one article, written by Subramoney which talks about the advantages of debt funds over fixed deposits when one stays invested for several years (much more than 5!): Money Control article dated Nov 26, 2011: Advantages of debt funds over fixed deposits
Many readers maybe aware that, following Subra’s suggestion, I made a fixed deposit vs debt fund comparator to illustrate his point. In this post, I present the second version of this calculator to with additional options.
Before we get to the calculator, we need to clear the air about certain issues:
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
Long term investing and debt funds
Use the phrases ‘debt fund’ and ‘long term’ in a sentence and immediately there are comments which read/sound, “One should invest only in equity for the long term”, “for more than 5 years one should always invest in equity”. Sorry I need to say this: such sentiments are plain dumb. People who say such things without understanding the context are often clueless about what asset allocation means.
- Every investor needs a debt instrument. Every portfolio needs a debt component, regardless of time frame. The same cannot be said about equity. Of course the percentage allocation to debt will vary depending on the time frame involved. However,the percentage is never zero.
- While investing for long term goals like retirement or a child’s education or marriage, a SIP is a debt ‘income’ fund is not a bad idea at all. This allows an investor to freely rebalance the portfolio.
- PPF is good but inflexible and cannot be used for rebalancing. A debt fund is a not a bad idea even for people who use PPF + equity MFs or EPF + equity MFs.
- Tax efficiency is important, but more important is preserving the fruits of compounding by rebalancing.
- Many times we receive a lump sum from various sources (bonuses, pay arrears, gifts etc.). If we are already saving enough for our goals then this lump sum can be invested in a debt mutual fund for a long period of time and be used to fund different goals.
- There are many more such uses. If you can think of some more, please do share them in the comments section so that all of us can benefit.
The advantage Income from both fixed deposits and debt funds is taxable. Debt funds are taxed at a constant rate for all investors: 10.3% without indexation or 20.6% with indexation (whichever is lower can be used). Tax on fixed deposits depends on the investors tax slab since it is added to income and taxed as per slab. For someone in the 20% or 30% slab choosing a debt fund can is advantageous over a FD especially if one stays invested for a long enough time (10 years or more). Even if someone is currently in the 10% slab, if he/she has a chance of moving to the 20% slab (or higher) after a few years, a debt fund investment is a good idea.
Income from debt funds is taxed only when an investor redeems the investment. However,there is a disagreement regarding when the FD income is taxable. Most people (include me, Subra and other CAs) are convinced that tax on FD income has to be declared and paid each financial year. Others believe tax on FD income can be paid on maturity like debt funds.
I consider this disagreement below and also offer both possibilities in the calculator.
If you choose to pay tax on FD income each year then the amount that is allowed to compounded each year is lower. In the case of a debt fund the entire fund-value participates in the compounding. So in this case, over a long enough period the debt fund corpus can be significantly bigger. Version I of the calculator considers only this possibility: Fixed deposit vs debt fund comparator
If you choose to pay on tax on maturity (tax in this context refers to tax over and above the 10.3% tax deducted by the bank (TDS)), then a much higher amount participates in the compounding. In this case the advantage held by the debt fund is typically lower but non-zero.
Fixed Deposit: nature of taxation As mentioned above there is a disagreement regarding when the FD income is taxable. Some CAs state tax on FD income has to be declared and paid each financial year. Other CAs disagree with this and state that the method of taxation is up to the investor. That is investors can choose to pay tax on FD on maturity (by tax I refer to tax over and above the TDS) or they can choose to pay tax each FY. However the directives in this connection indicate that the method of taxation should not be changed as and when the depositor pleases. My cousin, Mr. Vishwanathan Ravi a CA (a man of great integrity and competence) disagrees with me. He has shared some information on this topic: Accounting policy cash vs. accrual
Food for thought indeed. I am however convinced that FD income should be declared and paid each year. The most recent directive in this regard makes me think this way. You could refer to this FD calculator post for all relevant links regarding this.
Please consult a CA before making a decision in this regard for your FDs and RDs.
What about volatility? Yes debt fund volatility will reduce the final return (CAGR). To take this into account, you could use a conservative debt fund return in the calculator and a reasonably accurate value of FD return. It will be even better if you know about different debt instruments and choose a conservative return that reflects the typical volatility of each fund category.
Note: Volatility is almost always short term. For debt funds it is typically much more shorter than equities. So if you invest in a debt fund for several years, volatility will not affect you much.
The debt fund return used in the calculator is the final average return (CAGR). That is the volatility is bundled in. I am working on a calculator which takes into account annual debt fund returns. I am convinced that the arguments presented here will remain unchanged.
I am also convinced that even with high volatility (due to FII, RBI etc.), debt funds left undisturbed for several years will outperform FDs for those in the 20% and 30% slabs. Of course those in the 30% slab can afford to take more risks with their debt fund choices.
Calculator: As mentioned earlier this is the second version of the debt fund vs. FD comparator. In this version, the post-tax FD and debt fund (with and without indexation) returns are computed and plotted as functions of the investment duration (1-30 years) using a macro.
Make up your own mind: Compare the performance of debt funds against FDs, for different tax slabs, investment durations and interest rates. You can see which method of FD taxation is efficient and when debt funds are advantageous for a given method.
Updated version: Budget 2014: Debt Mutual Funds vs. Fixed Deposits
Download the debt fund vs. fixed deposit comparator version II (.xlsx)
Download the debt fund vs. fixed deposit comparator version II (.xls)
Note: Macros must be enabled. Before running the calculator please spend a few minutes looking at the inputs and outputs to get a feel for the advantage mentioned in this post.
Feedback:
- What is your take on this issue?
- Do you have suggestions to improve this calculator? (I am working on a version which uses historical returns)
Related articles
- Is This Financial Literacy?
- Investors Cannot Eat Their Cake And Have It Too!
- Comprehensive Fixed Deposit Calculator – I: Total and Advance Tax Liability
- Comprehensive Fixed Deposit Calculator – II: The Income Clubbing Headache
- Step-by-Step Guide to Selecting a Mutual Fund
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)