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.
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.