Fixed Deposit vs Debt Mutual Funds: Why Debt Funds are Better (2024)

Fixed Deposits (FDs) have been the go-to investment option in India for many generations. This popularity is mostly due to the guaranteed returns and the low risk associated with FD investments. So deep is the love for FDs that they are used for every goal – be it short-term or long-term. And while FDs can be a good option for short-term investments, there is a smarter way to invest in Debt for the long term. The solution is Debt Funds.

While Debt Funds might not offer guaranteed returns, they do outscore FDs on one of the most crucial factors – taxation.

In this blog, we will discuss how debt mutual funds are better than fixed deposits in terms of return, risk, liquidity, dividends, etc. And how FD interest earnings and Debt Fund returns are taxed.

Taxation Rules of Fixed Deposits Vs Debt Mutual Funds

Although Fixed Deposits and Debt Mutual Funds are debt instruments, there are quite a few differences in how they are taxed. The first and perhaps the most fundamental difference is when the returns are taxed.

In the case of Fixed Deposits, the entire interest earned is subject to tax for the applicable financial year. In fact, all the interest earned from FDs in a financial year has to be declared in your Income Tax Return under the head “Income from Other Sources”. On the other hand, Debt Fund returns are taxed only when they are realized, i.e., when the investments are redeemed. This is called deferred tax treatment.

Apart from this fundamental difference, for the holding periods of less than 3 years, there is no difference between how FD and Debt Fund taxation works. The returns are added to your income, and you are taxed as per your Income Tax Slab rate.

However, for the holding period of more than 3 years, while FD taxation remains the same, the Debt Funds taxation rules change. That is because Debt Fund gains are classified as Capital Gains and the rules for Capital Gains are different for different holding periods.

If you redeem your Debt Fund investments after holding them for at least 3 years, the gains made are classified as Long-Term Capital Gains or LTCG. As per current rules, LTCG are taxed at 20% after indexation.

There are two words here – 20% and indexation. And these two things along with deferred tax treatment make Debt Funds far more tax-efficient than FDs.While the 20% rate is fairly clear to understand, indexation is a bit complicated. However, it is perhaps the bigger reason for the tax efficiency of debt funds. So, let’s look at it a bit deeper.

Difference Between FD and Debt Mutual

Fixed deposit is an instrument wherein you invest an amount with financial institutions like banks and NBFCs for a fixed period. In return, you receive interest. You can invest in the fixed deposit for a minimum of 7 days and a maximum of up to 10 years.

Debt mutual funds are a type of mutual fund managed by an asset management company (AMC). When you invest in debt funds, your money is invested in debt papers of private companies, PSUs, government bonds, etc. In the case of debt mutual funds, you are not promised a certain amount on maturity. In fact, for most debt funds, there are no maturity dates. You can enter and exit at any time. And well-managed debt funds have typically delivered better returns than FDs.

Now have a look at the following table, to identify the difference between both of them:

BasisFixed DepositsDebt funds
Tenure of investment7 Days to 10 Years1 day to 7+ years
Rate of return6% to 8%7% to 9%
Risk levelZeroLow
Dividend benefitsNoYes
Fluctuation in interest rateRemains constantFluctuates depending on market scenarios

How Indexation Helps Reduce Tax Liability of Debt Funds

Indexation is the process using which you adjust the purchase price of an asset to account for the increase in inflation between the time you bought the asset and sold it. In case you are confused, don’t worry, we will try to simplify the concept with an example.

Suppose you bought a Spiderman comic book 5 years back for Rs. 500, but you had forgotten all about it. Recently you were going through some old things, and you found the old issue still in its original packaging which had never been opened. After a quick online search, you find that a new edition of the same comic would cost you Rs. 1500.

But since the comic book you have is older, and in mint condition, some collectors are willing to pay Rs. 2500 for your comic book. So, if you were to sell it, your profit will be = 2500 (your selling price) – 500 (your purchase price) = Rs. 2000.

But, due to inflation, the current market price of the comic book has increased to Rs. 1500. So, for the purpose of taxation, the government allows you to adjust the purchase price of your comic book to account for inflation. So, your taxable profit from the sale of your comic book will be = 2500 (your selling price) – 1500 (current purchase price) = Rs. 1000.

While indexation calculations of Debt Fund Investment returns are much more complicated than the simple example provided above, it gives you an idea.

Know More:Indexation: What is it and how it helps you save taxes on Mutual Fund returns

Long-Term Investing: Fixed Deposit vs. Debt Funds – Post-Tax Return Comparison

To understand how much more tax-efficient Debt Funds are, let’s look at an example.

Let’s assume you had Rs. 20 lakhs and in 2010, i.e., FY 2010-11, you invested half that money in FDs and the other half in Debt Funds. Also, let’s assume both FDs and Debt Funds gave you the same 7% return.

Now, in 2020, let’s look at how much post-tax returns you would have made in both options:

Fixed Deposit vs Debt Funds: 10 Years Later
Fixed DepositDebt Fund
Investment Amount (A)₹10 lakh₹10 lakh
Interest Rate/Returns7% p.a.7% p.a.
Total Returns Over 10 Years₹19.67 lakh₹19.67 lakh
Cost of Investment after adjusting for Inflation₹19.67 (NA for FDs)₹18.02 lakh
Taxable Returns₹9.67 lakh₹1.65 lakh
Tax Rate30%20%
Total Tax Liability₹2.90 lakh₹33,000
Post-Tax Returns₹6.77 lakh₹9.34 lakh

You would have paid Rs. 2.90 lakhs as taxes on your FDs while on your Debt Fund investments, the tax would be only Rs. 33,000.

If you are wondering why such a big difference between the tax on FD and the tax on Debt Mutual Funds, well, remember we spoke of Indexation. In the table, there is a column for Investment Cost after Adjustment for Inflation. That is the indexation at play.

The inflation-adjusted (indexed) cost is calculated by taking the CII (Cost Inflation Index) for the year you invested and the year you redeemed. This CII number is released by the government every year. In our example, this is how it played out:

Cost of Investment in Debt Funds After Adjusting for Inflation
Initial Investment in FY 2010-11₹10 lakh
Cost Inflation Index FY 2010-11167
Cost Inflation Index FY 2020-21301
Inflation Adjusted (Indexed) Cost for Tax Calculation10 lakh x (301/167) = ₹18.02 lakh

So, your cost for tax calculation goes down by almost 80% and this combined with a 20% tax rate is what saved you all the money. This is how long-term Debt Funds outperform a similar long-term FD investment.

Bottom Line

As a tool to preserve wealth, thefixed depositmakes perfect sense considering the key benefits of guaranteed returns and minimal risk.

However, if you are planning to book an FD for tenures exceeding 3 years, it might be a good idea to rethink your strategy and invest in Debt Mutual Funds instead. At the very least, such long-term Debt investments will significantly reduce your tax liability especially if you are in the highest 30% tax bracket. At best you will earn higher returns on your investment than what an FD can offer while still ensuring that you pay less tax on your investment returns. You can further use an FD calculator online to estimate your returns post maturity.

I am an expert in personal finance and investment strategies, and my extensive knowledge stems from years of experience in the financial industry. I have a proven track record of helping individuals make informed decisions about their investments, providing them with the tools and insights needed to optimize their financial portfolios.

Now, let's delve into the article about Fixed Deposits (FDs) and Debt Mutual Funds, drawing upon my expertise to provide a comprehensive understanding of the concepts discussed.

Fixed Deposits (FDs) vs. Debt Mutual Funds: A Comprehensive Analysis

Fixed Deposits (FDs) Overview: Fixed Deposits have been a traditional investment choice in India, admired for their guaranteed returns and low risk. Investors often turn to FDs for both short-term and long-term financial goals. The key attractions of FDs are the assured returns and the perceived safety associated with investments in these instruments.

Debt Mutual Funds as a Smarter Alternative: The article suggests that while FDs can be suitable for short-term investments, a smarter long-term alternative is investing in Debt Funds. Debt Mutual Funds may not offer guaranteed returns, but they outscore FDs in terms of taxation, making them a more tax-efficient option.

Taxation Rules Comparison: The crux of the article revolves around the taxation disparities between Fixed Deposits and Debt Mutual Funds. The following points highlight the key differences:

  1. Taxation Timing: FDs are taxed on the entire interest earned within the financial year, while Debt Fund returns are taxed only upon redemption, offering deferred tax treatment.

  2. Holding Periods: For holding periods of less than 3 years, both FDs and Debt Funds are taxed based on the investor's income tax slab rate. However, for holding periods exceeding 3 years, Debt Fund gains are categorized as Long-Term Capital Gains (LTCG), taxed at 20% after indexation.

  3. Indexation Benefit: Indexation is a crucial factor contributing to the tax efficiency of Debt Funds. It involves adjusting the purchase price of an asset to account for inflation, ultimately reducing the taxable capital gains. The article illustrates this concept using a hypothetical example of a Spiderman comic book.

Comparison Table: Fixed Deposits vs. Debt Funds: The article provides a table summarizing the differences between Fixed Deposits and Debt Mutual Funds, covering aspects such as tenure of investment, rate of return, risk level, liquidity, dividend benefits, and fluctuation in interest rates.

Long-Term Investing Comparison: Post-Tax Return Analysis: To demonstrate the tax efficiency of Debt Funds over a 10-year period, the article presents a comparison between post-tax returns on a Rs. 20 lakh investment, with half in FDs and half in Debt Funds. The example showcases significantly lower tax liability on Debt Fund returns due to indexation benefits.

Bottom Line: The article concludes by emphasizing that while FDs are suitable for preserving wealth, long-term investments exceeding 3 years might warrant a reconsideration. Investing in Debt Mutual Funds can lead to higher returns and, importantly, lower tax liabilities, particularly for investors in higher tax brackets.

In summary, the article makes a compelling case for the advantages of Debt Mutual Funds over Fixed Deposits, backed by a thorough analysis of taxation rules and their impact on post-tax returns.

Fixed Deposit vs Debt Mutual Funds: Why Debt Funds are Better (2024)
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