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Typically, it is believed that both fixed deposits (FDs) and debt funds face similar taxation, barring the inflation indexation benefit given only to the latter. But here is another reason why debt funds could do much better than FDs.
We stumbled upon this when a client with a high pension income (20 per cent income tax bracket) approached us. He needed to supplement his pension income through a strategy of investing a lumpsum in a one-year renewable fixed instrument. Every year he wanted to withdraw the interest and a part of the principal, a total of Rs 3.6 lakh, for his additional expenses. This investment was to be continued for five years.
The initial idea was to invest in a one-year FD. But after a little more research, we discovered that the debt mutual fund route could be a more tax-efficient one. The reason: in the case of FDs, the entire interest would have had to be withdrawn annually and taxed at 20 per cent. On the other hand, when withdrawals are done from the debt fund, only the portion that is withdrawn at the excess net asset value (NAV) would be taxed at 20 per cent.
Consequently, the requirement of initial investment in the debt fund fell by 2.5 per cent, besides the tax benefit. Here's how it works. To withdrawn Rs 3.6 lakh annually for five years, he needed to invest in a renewable FD of Rs 14.68 lakh. Assuming nine per cent interest rate on the one-year FD, at the end of the first year, the interest income would be Rs 1.32 lakh. The tax at 20 per cent: Rs 26,428. After the withdrawal of Rs 3.6 lakh, he would have a principal of Rs 12.13 lakh.
On the contrary, partial withdrawal from the debt mutual fund would attract a similar tax rate of 20 per cent but there is also an indexation benefit after three years. Assuming the same interest rate of nine per cent and an inflation indexation benefit of six per cent, the initial investment would have to be Rs 14.32 lakh, a saving of Rs 36,172 or 2.5 per cent.
Over a longer period, say 30 years, the upfront savings can be significantly more at 17 per cent. The liquidity and safety aspects of an appropriate debt mutual fund can compare very well with a bank FD and, hence, this is a must-see for every retired person looking to generate a regular income for a substantial periods of time from safe fixed income instruments.
The author is director, Apnapaisa
