Debt Funds Vs Bank FDs – Which is more tax-efficient in the long run?

Debt Funds Vs Bank FDs – Which is more tax-efficient in the long run?

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In India, fixed deposits (FD's) continue to dominate the terrain of ‘comfort investments’ for a sizable section of investors, to guaranteed returns & low risks associated with fixed deposit investments, they have been the go-to investment option in India.

However, the tide is slowly turning against fixed deposits, not that people are moving to other investment avenues en masse & ditching FD's completely, but the realization is slowly gaining ground among a section of investors that returns offered by FD's may not be enough to beat inflation in the long run. Interest rates have been slipping since the last few years & lower rates tend to bring down yields on bank FDs. Add taxes to the mix & the investor is left with little in the name of profit. The returns offered by any long term investment avenue can be significantly eroded because of taxation policies.

This is slowly pushing more investors, especially those who want to avoid the riskier equities route to tap into debt funds. Depending on the fund you have invested in, debt funds can offer more impressive annualized returns & what’s more besides coupon payments you can also earn capital gains when bond prices go up as a consequence of falling interest rates. In terms of long term benefits debt funds outscore FD's when it comes to taxation.

Taxation on FD interest earned & Dividends on Debt Funds :

The interest that you earn on bank FD's is considered as your income when it comes to tax compliances. Your FD interest will fall under the subhead ‘Income from Other Sources’ in your Income Tax return. For example, if you fall in the 30% tax bracket & invest ₹ 10,00,000 in an FD for a year that offers 8% interest, your total corpus on maturity will amount to ₹ 10,82,999 and your gains after taxes will be ₹ 10,57,104 which effectively means that your post tax yield is around 5-6% which may not be high enough to tackle inflation in the long run.

One can argue that when it comes to debt funds, the dividend taxation is a villain especially after an amendment was made in the Union Budget 2020 that mandated that dividends received by investors would be added to their taxable income & taxed at their respective income tax slab rates. Previously, dividends were tax-free in the hands of investors as the companies paid dividend distribution tax (DDT) before sharing their profits with investors in the form of dividends. But what makes the case stronger for debt funds despite the dividend taxation conundrum is the fact that the dividend payout is an option that you can choose as an investor & if the tax bite is too much, you can always opt for the growth option.

Taxation on Capital Gains :

The fundamental difference between how fixed deposits & debt mutual funds are taxed is based on when the returns are taxed. For holding period less than three years there is no difference in how FD's & debt funds taxation work – the gains will be added to your income & you will have to pay income tax according to your income.

However, when the holding period is more than 3 years, the FD taxation formula remains the same but the taxation on debt funds changes. After three years, debt fund gains are classified as capital gains & the tax slabs differs for varying holding periods. If your debt funds have been held for more than three years, the gains would be classified as Long Term Capital Gains which attracts taxes of 20% with indexation & 10% without indexation. Indexation adjusts the purchase price of an asset to account for rise in inflation in the period between the purchase & sale of the asset. In the long run, indexation reduces your capital gains & ultimately your tax liabilities.

Another difference comes into play when you factor in TDS (tax deducted at source). For FD's, TDS is applicable on the interest earned if it is more than ₹ 40,000 a year (general citizen) & ₹ 50,000 a year of you are a senior citizen. You can adjust TDS with your tax liability by submitting Form 15G/15H to the bank & later claim a refund but it is a tideous procedure, whereas, with debt funds, you do not have to worry about TDS being levied when you sell your units.

Besides higher returns & lower tax burdens in the long run which would give you an extra mileage in the race against inflation, debt funds are also highly liquid and you can redeem them at a very short notice.

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