Defer taxes to power compounding!

Published: September 2, 2016 at 5:34 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(

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

  1. by deferring tax upto maturiy is 3,52,972
  2. 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,

  1. by paying tax each financial year, the 2o-year FD maturity value  is 2,93328
  2. 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

Do share if you found this useful

Use our Robo-advisory Excel Template for a start-to-finish financial plan! Now with a new demo video!  More than 640 investors and advisors use this!
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 2525 investors and advisors are part of our exclusive Facebook Group! 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 in an exclusive Facebook Group! 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 585 salaried employees, entrepreneurs and financial advisors are part of our exclusive Facebook Group! 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 in an exclusive Facebook Group!   
My new book for kids: “Chinchu gets a superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both boy and girl version covers of Chinchu gets a superpower.
Most investor problems can be traced to a lack of informed decision making. We have all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, if we had to groom one ability in our children that is key not only to money management and investing but for any aspect of life, what would it be? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parent’s plan for it and teach him several key ideas of decision making and money management is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
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 for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Did you know? We have more than 1000+ videos on YouTube to explore! Join our YouTube Community!

Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!), or you buy the new Tactical Buy/Sell timing tool!
We publish mutual fund screeners and momentum, low volatility stock screeners .every month.
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored three print books, You can be rich too with goal-based investing (CNBC TV18), Gamechanger, Chinchu Gets a Superpower! and seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations based on money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association, IIST Alumni Association. For speaking engagements, write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. 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 from credible and knowledgeable sources before publication. Freefincal does not publish any paid articles, promotions, PR, satire or opinions without data. All opinions presented will only 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
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions, seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis 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

Travel-Training-Kit-Cover-new This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, 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 199 (instant download)
Free android apps