FD rates have increased but post tax returns still low: What should you do?

Deposits are still the most preferred instrument of saving in India although market-based instruments are gaining share, according to an article published in the Reserve Bank's July Bulletin.As per the last SEBI survey in 2017, an overwhelming 95 per cent of Indians swore by fixed deposits. The rationale is that FDs are safe and offer guaranteed returns. 

Even though fixed deposit rates have increased in the recent past, post tax returns are still low, according to an analysis by FundsIndia. 

Source: Respective Bank Websites (for deposits below 2cr), FundsIndia Research. As on 30-Jun-2024. *Taxation at the rate of 30% has been considered.

 

Debt funds, which have historically delivered 6-8 per cent over five plus years, might be a better option. 

Capital gains from new investments in Debt Funds are now taxed as per your individual slab rates irrespective of the holding period. Previously, Debt Funds had a taxation advantage over FDs (gains from debt funds held for 3+ years were taxed at 20% post indexation). This change has put the taxation of Debt Funds at par with FDs. Therefore, the choice between Debt funds and FDs will primarily be made on merit of the product vs the taxation rate differential. 

How to read the table: Column 1 indicates the starting date of SIP. The Row named ‘Year’ indicates the time frame on investment – 1Y, 2Y, 3Y etc Source: MFI, FundsIndia Research. *Debt: Index calibrated based on the Debt Schemes - Aditya Birla SL Low

FundsIndia compares Debt Funds to Fixed Deposits and see which one fares better.

Diversification

FD: When you invest in a fixed deposit, you are essentially lending money to a single borrower i.e. your bank.

Debt Funds: When you invest in a debt fund, your money is split and loaned to multiple borrowers. Eg: Central & State Governments, PSUs, Banks and Corporates. This leads to much better diversification.

Flexibility of Withdrawal

FD: A premature withdrawal penalty is generally charged if you want to exit your investments early. It is also not possible to systematically withdraw money from your FDs.

Debt Funds: In most debt funds, the money can be withdrawn anytime without any exit penalty. Further, you have the option to automate your money withdrawals every month by setting up an SWP (Systematic Withdrawal Plan).

Compounding

FD: FD returns are taxed every financial year. This is regardless of whether you choose to receive interest every year or on maturity.

For example, let’s say you invest Rs 10 lakh in a 5-year FD at 6% interest. Here you will have to pay at least Rs 18,000 in tax (assuming 30% slab) every year. Plus, the regular interest payouts and TDS deduction in FDs also affect compounding.

Debt Funds: Unlike FDs, debt fund gains are taxed only when you redeem. This allows better compounding of returns over the long term. In debt funds, you also have the option to plan your redemptions in such a way that your tax outlay is reduced. You can lower the tax amount to as much as zero if you use debt funds for post-retirement goals (similar to EPF).

All these result in better compounding outcomes in case of debt funds.

Safety

FD: In fixed deposits, the credit risk (read as the chance of not getting your money back) generally tends to be low especially for large banks. Moreover, the overall bank deposits up to Rs 5 lakh

 are insured – which adds to comfort.

Debt Funds: Here the credit risk varies from low to high. But this risk can be minimised to a large extent by choosing debt funds with high credit quality.

Return Predictability

FD: The returns are predictable and can be known at the time of investment. There are no fluctuations in your returns unless the bank faces some issues.

Debt Funds: There can be some fluctuations in your returns due to yield movements. The return predictability is therefore lower compared to FDs. 

"If fixed returns at little to no volatility is your priority, then you can go for fixed deposits.  But if you are willing to tolerate mild volatility, Debt funds are clearly better than FDs despite the taxation changes. 
 

 This is because Debt funds provide the potential for extra returns when interest rates fall, better compounding as returns are taxed only during withdrawal, flexibility to withdraw anytime without penalties, and better diversification," said Shrinath ML, senior research analyst at FundsIndia.

So, how to invest?

Srinath prefera debt funds with High credit quality (>80% AAA exposure) and Short duration (investing in 1-3 year segment) or target maturity funds (investing in 3-5 year segment). Investors who do not mind slightly higher volatility can also pick Arbitrage Funds and Equity Savings Funds which enjoy Equity taxation.