Debt Mutual Fund is better than Bank Deposit

Debt Mutual Fund is better than bank deposit even after the changes in budget for 2014-15.

Lot of noise is around the corner regarding the way taxation has changed for debt mutual funds in the recent budget for 2014-15. Finance minister has reduced the arbitrage advantage enjoyed by the debt funds. Debt mutual funds are still attractive for the investors. Why you should invest in debt funds? Whether debt funds are better than bank deposit? To know the answer, please see the example given at the end of this article.

Types of Debt Mutual Fund

Depending on the type of investments, debt mutual funds are divided into various categories. Different types of debt funds are:

1. Liquid Funds
2. Ultra Short Term Funds
3. Income Funds
4. Hybrid Funds
5. FMPs

Advantages of debt funds

Debt funds offer several advantages to investors. They are:

1. Easy liquidity:  The withdrawal from debt fund is very easy. If you redeem your investment today, the money will be in your bank account on the next working day. Another great advantage is the facility of partial withdrawal from debt fund. For example, if you have 2 lakhs in a debt fund, you can withdraw as per your convenience in small lots, while the balance will continue to grow in the fund. Such things will be difficult in the case of a bank deposit.
2. Flexibility in investing: You can invest any amount in a debt fund.  After that, as and when you have surplus, you can invest in the same folio. If you transact online, you can do this very easily. Such flexibility is not there in a bank deposit.
3. Systematic withdrawal plan: This is most suitable for retired persons who want to receive a fixed amount every month. If you have investment in a debt fund, you can opt for a withdrawal of a fixed amount every month as per your need. You have the flexibility to increase or decrease the monthly amount. If you want additional withdrawal at anytime, that is also possible. It is almost like SB account offering higher returns.
4. Transfer to equity funds: If you have a lump sum to invest in equity funds, going for a systematic transfer (STP) will be an ideal way to do this. If you want to invest 2 lakhs in HDFC top 200 Fund, you may first invest the full amount in HDFC liquid fund. Then you can opt for a STP of 20,000 for the next 10 months. This will help you in averaging your cost like in the case of SIP. Your money in liquid fund will earn a decent return as long as the amount is there. Similarly, if you feel that the market is peaking and there can be a crash, you can easily transfer your accumulation to debt funds to protect the savings. This is required when you are nearing your financial goals.
5. No TDS: In bank deposit, the bank will deduct TDS at the rate of 10% if the interest income exceeds 10,000 in a year. If you are not in the taxable range, you have to submit form 15G or 15 H to avoid TDS. But in debt funds there is no TDS.
6. Postpone your tax liability: In the case of bank deposits, you are liable to pay income tax on the interest every year on an accrual basis. You will get the maturity proceeds of a 5 year FD only after 5 years, but you are liable to pay tax from first year on the accrued interest. But in the case of debt funds, you are liable to pay tax only at the time of redemption. This way you can postpone your tax liability.
7. Debt mutual funds are more tax efficient than bank deposits: In the case of bank deposit, the entire interest is taxed according to your slab rate. Though the bank is deducting 10% as TDS, you are liable to pay the balance tax of 20%, if you are in the 30% tax slab. Otherwise, you will get a tax notice from income tax department. But the income from debt funds is treated as capital gains. After 3 years, the capital gain is long term in nature and is taxed at 20% with indexation. The indexation will help you to offset the effect of inflation on your investment and will reduce your tax liability to almost nil in periods of high inflation.

The following example shows how debt funds are superior to bank deposits mainly for those in the higher tax slabs.

Ramesh invested 10 lakhs in bank deposit on 1^st April 2008 for a 5 year period. The rate of interest was 9%. He was in 30% tax slab. The bank deducted 10% TDS from the interest income and he was paying the balance 20% tax every year.

The chart given below shows the growth of his investment in the 5 year period.  He got 13, 71, 103 on 1^st April 2013 after all tax liability. If you calculate the effective return, it is around 6.5% for the last 5 years. The return is reduced because the tax liability was discharged every year and only the balance amount was reinvested.  Bank deducted 10% TDS and he was paying another 20% every year.

His friend Mahesh invested 10 lakhs in a debt fund on 1^st April 2008 and he redeemed the investment on 1^st April 2013. At 9% return, he got 15, 38,623.  This is 1, 67,520 more than what Ramesh got.  The gain of 5, 38,623 is 45% more than what Ramesh got as interest!

Is there any tax liability for Mahesh?

The long term capital gain in this case is 5, 38,623.  But he need not pay tax on this amount. As per the rule, he has to pay tax at the rate of 20% after indexation.

Let us calculate the indexed cost of his investment. The cost of Inflation Index (CII) for 2008-09 was 582 and that for 2013-14 was 939.

The indexed cost of investment = 10, 00,000 x 939/582 = 16, 13,402.

As per the rule, he has to pay tax at the rate of 20% for any gain in excess of 16, 13,402. But in this case he got only 15, 38,623. For taxation purpose, it will be calculated as a long term capital loss of 74,779 (16, 13,402 -15, 38,623 = 74,779). So, he need not pay any tax on his gain of 5, 38,623!

What is more? He can adjust this loss against any other capital gain and reduce the tax liability in that year. He can even carry forward this loss of 74,779 to the next 8 years and adjust it against any future capital gain!

Debt funds are much beneficial than bank deposits if you are in the higher tax slabs and if your investment horizon is 3 years or more.

If you are keeping huge amount in bank deposit, moving it to debt funds can be a better option for the long term wealth creation. But select the debt funds depending on your risk profile. While there is no much interest rate risk for liquid funds and short term debt funds, long term funds can be volatile as per the interest rate movement.

Prior to the budget 2024-15 announced on 10^th July, 2014, your gains from debt fund investment were treated as long term, if the investment period is 1 year or above. As per the budget 2014-15, this has been changed to 3 year. The tax rate is 20% with indexation benefits. Earlier it was 10% without indexation or 20% with indexation. FMPs of less than 3 year duration will lose the tax advantage as per this budget.

If you are ready to hold your investment in debt funds for 3 years or above, nothing has changed for you in this budget. You will pay 20% tax on the long term capital gain after indexation as earlier.