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:
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
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.
- 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)