Last Updated on September 2, 2016 at 5:35 pm
A financial instrument that lets you defer paying taxes until maturity is way superior to one where you need to report and pay tax on the income generated each year of investment. That is the single most important reason why debt mutual funds are superior to fixed deposits. This is an illustration of the power of compounding with deferred taxation, suggested by subra(money.com).
I have already illustrated this point here: Budget 2014: Debt Mutual Funds vs. Fixed Deposits and in other posts. Subra felt it would nice to have a generic deferred taxation calculator and hence this post.
First let us look fixed deposits alone. There are two ways in which you can pay taxs: (1) pay each year, (2) pay upon maturity. A court has ruled that every citizen has a right to choose the style of accounting and taxation – pat each year or upon maturity. However, they cannot change style once made. More details about this with documentation can be found here: Debt Mutual Fund vs. Fixed Deposit Comparator – Version II
Unfortunately FDs and RDs have TDS. This means that even if you choose to pay tax upon maturity, 10.3% tax as TDS would get deducted each financial year. Therefore it would be a mess to split the taxation in two different ways – TDS, and maturity) from the point of view of ITR. In todays connected world, the ITO is already serving up pre-filled ITR forms. The banks have our PAN no and we declare bank details while filing.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! 🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
So sooner or later, the TDS would be an auot-filled entry when we set to file ITR. Therefore, deferring tax on FD until maturity can be a nightmare if the IT dept senses a red flag and calls an enquiry. One may quote rules, but there is no guarantee that the assessing officer would buy that.
Conclusion: Even if you don’t have to, it is prudent to pay tax on FD interest each year.
As a simple illustration of the power of compounding with deferred taxes, consider a fixed deposit where gains are taxed as per slab with no TDS.
For an individual in the 30% slab investing 1,00,000 in a (hypotherical) 20 year(FY) old fixed deposit at 8% return compounded annually, the final corpus
- by deferring tax upto maturiy is 3,52,972
- by paying tax each financial year is 2,93328
A difference of 59,644 or about 20% more. This is simply because, by paying tax on the gans each year, the amount left to compound is lesser. Higher the duration, more would be the impact.
Note: It is innumeracy to argue that the FD grows untouched and I paying taxes out of a different pocket and not distrubing the compounding.
Now instead of a fixed deposit, had a debt fund been chosen, 8% before tax is a pretty reasonable return over 20 years. Before 3 years (if redeemed) the gains would be taxed like a fixed deposit – added to income and taxed per slab.
After 3 years, the tax rateis 20.6% and the gains will have to be calculated after hiking the investment amount by the cost inflation index. For the present illustration we will assume that cost inflation index grows each year at the rate of 5% (again reasonable).
So we have,
- by paying tax each financial year, the 2o-year FD maturity value is 2,93328
- by deferring taxes until redemption and using indexed capital gains for taxation, the maturity value with a debt fund is, 4,24,738.
A difference of 1,31,410 – deferring taxes and taking advantage of the lower tax slab results in a significant difference (~ 45%) in corpus.
These illustatrions may seem obvious to you.
Now what if the tax slab of the person was 10% for the next 20 years? Entirely possible for a retiree. Should such a person invest in fixed deposits or in debt funds?
For each of those 20 years, the FD would be taxed at 10%. For the first 3 years, the debt fund would be taxed at 10% and then 20% with indexation (when redeemed).
As counterintuitive as it seems, the debt fund is better!
For 1,00,000 invested, the FD (with 10% tax paid out each year) would yield, 3,99,900
The debt after 20 years (with 20% tax on indexed gains) would yield 4,24,738.
This is only a 6% difference and once argue the comfort of FDs is better for those in the 10% slab. I agree with that. However, I think it is clear that deferring taxes powers compounding.
Here is a calculator with which you can play around to get a feel for this idea.
Download the power of compounding with deferred taxation calculator
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
- 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 with 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 over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
Explore the site! Search among our 2000+ articles for information and insight!
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, 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 what 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 you 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!
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 & it's 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 analysis 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)