Debt mutual funds more tax efficient than bank FDs

For most investors, fixed deposits and small savings schemes are the favourite debt options. But though fixed deposits and small savings schemes offer assured returns, the interest earned is taxed at normal rates applicable to the investor. In the 30% tax bracket, the 6% interest earned on the fixed deposit is reduced to 4.2% after tax. NSCs are currently offering 6.4%, which will be reduced to around 4.4% post tax in the 30% tax bracket. The gains from debt funds are also taxable, but at different rates. If held for less than three years, the gains will be taxed at the same rate as the interest from fixed deposits.

But if you remain invested for more than three years, the gains from debt funds will be treated as long-term capital gains. They will be taxed at 20% after indexation. Indexation takes into account the consumer inflation during the holding period and accordingly raises the purchase price of the asset to adjust for inflation. Here’s how it works. If you bought an asset for `10,000 three years ago and the cost inflation index has risen 15% since then, the asset will be deemed to have been purchased for `11,500. Experts say high inflation is here to stay for sometime, which means indexation can bring down the effective tax significantly.

But mutual funds are market linked products, and their NAVs fluctuate as per the movement of bond yields. The RBI’s Monetary Policy Committee is meeting later this week on 3 November. If rates are hiked, as some analysts fear, the bond yields will shoot up. This will push down the NAVs, so risk averse investors may get unnerved. But there are some mutual funds that offer a semblance of certainty to the returns earned. Target date funds invest in bonds and hold them till maturity, thus assuring investors a certain return on investment. The yield to maturity of the fund is the indicative return an investor will get at the end of the fund’s tenure. Right now, many target date funds have yield to maturities of over 7%. Given the high inflation, the post-tax return from a target date fund with a YTM of 7% and held for more than three years can be as high as 6.75%.

How debt funds score over fixed deposits
If held for more than three years, returns from debt funds are much higher.