Here, I am arguing a case for debt mutual funds against FD, mainly on the account of the difference in the tax treatment for these two instruments.
Tax Treatment:
FD: Interest is taxed on accruals. I agree that you can opt to show on cash basis - but it is impractical to follow the same. Taxation: Clubbed into the total income for the year and taxed at the applicable tax slab.
Debt Mutual Funds: Taxed on the realized capital gains. The capital gains can be classified as short term (if the units are held for less than or equal to 3 years) or long term (> 3 years)
The tax treatment of the short term capital gains is very similar to the FD interest - the gains are clubbed to total income and taxed at the applicable tax slab. The long term gains are taxed differently - The investor can choose to pay tax @ 10% of the gross long term capital gains or @ 20% of the indexed long term capital gains, whichever is lesser.
Illustrative Calculation:
Assume a person is in the 30% tax slab and he chooses to invest Rs 1L @ 10% per annum in FD, for 5 years.
This is how the calculation goes:
Year : Amount : Interest: Tax : NetAmount
Year 1 : 100,000 : 10,000 : 3,000 : 107,000
Year 2 : 107,000 : 10,700 : 3,210 : 114,490
Year 3 : 114,490 : 11,449 : 3,435 : 122,504
Year 4 : 122,504 : 12,250 : 3,675 : 131,079
Year 5 : 131,079 : 13,108 : 3,932 : 140,255
He ends up getting Rs 140,255 after 5 years, for Rs 100,000 invested in FD.
Instead if he were to invest in a debt mutual fund with a compound annual growth rate of 10%, the 1L would have become 1 L * (1.1) ^ 5 = Rs 161,051. Tax on the LTCG at 10% = Rs 6,105 (10% on the gain of Rs 61,051). The net amount will be Rs 154,946. A difference of approximately Rs 14700 compared to FD growing at the same rate - just because of the difference in tax treatment.
To put in a different way, to get the same amount of what FD @ 10% p.a would have fetched at the end of 5 years, a person can choose to invest in a debt mutual fund with a CAGR of only 7.7%. For 10 years, the equivalent CAGR is 7.6% and for 20 years it is 7.4%.
A preliminary conclusion is that the debt mutual funds are advantageous if held for long term. In the short term, the tax treatment is same - both are taxed at the applicable tax rate - or that's what it looks like. It is not actually so. Why?
Because the annual interest (accrued even if not paid) is taxed in FD whereas only the gains are taxed in a debt scheme. Our assumptions still remain: A person in 30% tax slab. FD @ 10% p.a. Debt mutual fund growing at 10% CAGR.
FD: Rs 1L invested.
End of 1 Year: Rs 10,000 interest and Rs 3,000 tax. Net Interest Receivable: Rs 7,000. Net gain 7% (Effective tax 30%)
Debt MF: Rs 1L invested. NAV Rs 10.00 Units Bought: 10,000
End of 1 year: NAV Rs 11.00 (10% growth) Units Available: 10,000 valued at Rs 11 = Rs 110,000
Redeemed Rs 10,000 = Rs 10,000 / 11 = 909.09 units sold, means the remaining 9090.91 units are untouched
Cost of 909.09 units = Rs 9090.9 Sale Price = Rs 10000
Gain = Rs 909.09
Tax @ 30% = Rs 272.73
Net Amount = Rs 10000 - Rs 272.73 = Rs 9727.27 Net gain 9.73%!! (Effective tax 2.73%)
So, if our assumed person needs a regular pay out, it is prudent to take the pay out as gains from an equivalent debt fund than as interest from FD.
Tax Treatment:
FD: Interest is taxed on accruals. I agree that you can opt to show on cash basis - but it is impractical to follow the same. Taxation: Clubbed into the total income for the year and taxed at the applicable tax slab.
Debt Mutual Funds: Taxed on the realized capital gains. The capital gains can be classified as short term (if the units are held for less than or equal to 3 years) or long term (> 3 years)
The tax treatment of the short term capital gains is very similar to the FD interest - the gains are clubbed to total income and taxed at the applicable tax slab. The long term gains are taxed differently - The investor can choose to pay tax @ 10% of the gross long term capital gains or @ 20% of the indexed long term capital gains, whichever is lesser.
Illustrative Calculation:
Assume a person is in the 30% tax slab and he chooses to invest Rs 1L @ 10% per annum in FD, for 5 years.
This is how the calculation goes:
Year : Amount : Interest: Tax : NetAmount
Year 1 : 100,000 : 10,000 : 3,000 : 107,000
Year 2 : 107,000 : 10,700 : 3,210 : 114,490
Year 3 : 114,490 : 11,449 : 3,435 : 122,504
Year 4 : 122,504 : 12,250 : 3,675 : 131,079
Year 5 : 131,079 : 13,108 : 3,932 : 140,255
He ends up getting Rs 140,255 after 5 years, for Rs 100,000 invested in FD.
Instead if he were to invest in a debt mutual fund with a compound annual growth rate of 10%, the 1L would have become 1 L * (1.1) ^ 5 = Rs 161,051. Tax on the LTCG at 10% = Rs 6,105 (10% on the gain of Rs 61,051). The net amount will be Rs 154,946. A difference of approximately Rs 14700 compared to FD growing at the same rate - just because of the difference in tax treatment.
To put in a different way, to get the same amount of what FD @ 10% p.a would have fetched at the end of 5 years, a person can choose to invest in a debt mutual fund with a CAGR of only 7.7%. For 10 years, the equivalent CAGR is 7.6% and for 20 years it is 7.4%.
A preliminary conclusion is that the debt mutual funds are advantageous if held for long term. In the short term, the tax treatment is same - both are taxed at the applicable tax rate - or that's what it looks like. It is not actually so. Why?
Because the annual interest (accrued even if not paid) is taxed in FD whereas only the gains are taxed in a debt scheme. Our assumptions still remain: A person in 30% tax slab. FD @ 10% p.a. Debt mutual fund growing at 10% CAGR.
FD: Rs 1L invested.
End of 1 Year: Rs 10,000 interest and Rs 3,000 tax. Net Interest Receivable: Rs 7,000. Net gain 7% (Effective tax 30%)
Debt MF: Rs 1L invested. NAV Rs 10.00 Units Bought: 10,000
End of 1 year: NAV Rs 11.00 (10% growth) Units Available: 10,000 valued at Rs 11 = Rs 110,000
Redeemed Rs 10,000 = Rs 10,000 / 11 = 909.09 units sold, means the remaining 9090.91 units are untouched
Cost of 909.09 units = Rs 9090.9 Sale Price = Rs 10000
Gain = Rs 909.09
Tax @ 30% = Rs 272.73
Net Amount = Rs 10000 - Rs 272.73 = Rs 9727.27 Net gain 9.73%!! (Effective tax 2.73%)
So, if our assumed person needs a regular pay out, it is prudent to take the pay out as gains from an equivalent debt fund than as interest from FD.
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