Investors
often believe that equity investing is risky and complicated, whereas investing
in Bank fixed deposits is as simple as parking your money in a deposit and
renewing it on maturity or use the interest earned for your day to day expenses.
Most of the friends I talk to use Fixed Deposit for fixed, safe and steady
returns for their money.
There
are few others who explore about other Fixed Income options and understand Debt
funds to some extent. They believe that, Debt funds are safer than Equity funds
and offer good returns. This is not the only benefit offered by Debt funds over
Equity funds but Debt funds can also help investors to get optimum tax
efficient returns.
This
article will help you to understand the difference in the taxation on Fixed
deposits and Debt funds and give you visibility about the tax efficient nature
of the Debt funds.
Let us take a simple example to understand this
better.
Mr.
Sanjay has invested Rs. 1 Lakh in Bank FD about one year back in October 2016
for a period of one year at the interest rate of about 7%. Now the FD has
matured in October 2017, and he has earned interest of about Rs. 7,000
(calculated as simple interest for the purpose of simplicity). His taxable
income in the current Financial year is above 10 Lakhs and hence his tax rate
is 30% on the income earned by him in this year. Due to this, he has to pay
Income Tax of about 30% on Rs. 7,000 which he has earned as an interest on
Fixed Deposit. Hence, his tax on the FD interest is Rs. 2,100. He has withdrawn
only the interest amount from the FD maturity amount for his day to day
expenses in October 2017.
Let us put this calculation in a table as
below:
|
Principle Amount
|
Interest Earned
|
Income Tax
|
Post Tax Income
|
|
1,00,000
|
7,000
|
2,100
|
4,900
|
Mr.
Manoj has invested the same amount of Rs. 1 Lakh in Short Term Debt Fund
(Growth Plan) in October 2016. Since his debt fund invested the same amount
into multiple Corporate bonds, Company fixed deposits, Government bonds and Money
market instruments, it has generated marginally higher returns than FD. The
current value of his investment is Rs.1,08,500.
Now,
let us calculate the tax which Manoj has to pay in case he decides to withdraw
only the profit /partial amount i.e. Rs. 8,500 from his debt fund in October
2017 for his day to day expense. Since this is not a Fixed Deposit, he has
freedom to withdraw any amount which he wishes to withdraw from the debt fund.
Since
he is withdrawing this amount after one year (which is less than 3 years
period), he has to pay Short Term Capital Gains Tax on this amount. Since he also
pays 30% income tax, the same rate is applicable to Short Term Capital Gains in
the case of Debt fund. So, the tax which he has to pay is 30% of the actual
gains. Out of the amount of Rs. 8,500 which he has redeemed, assume that, about
Rs. 7,850 was his original principal amount, hence his short-term capital gains
are about Rs. 650 only (Rs. 8,500 – Rs. 7,850) on which he has to pay tax of
Rs. 195 only.
Let us put this calculations in a table as
below:
|
Principle Amount
|
Profit Earned
|
Income Tax
|
Post Tax Income
|
|
1,00,000
|
8,500
|
195
|
8,305
|
As
you can see, both Sanjay and Manoj have gained about Rs. 7,000 and Rs. 8,500 as
interest or as capital gains (profit), and while both of them have withdrawn
only the interest or the profit, Manoj has to pay only a fraction of the Tax as
compared to Sanjay. So, not only he has earned Rs. 1,500 more by investing in
Debt fund, but also, he has to pay only a fraction of the tax.
This example highlights tax efficient nature of
Debt funds as compared to Bank fixed deposits. Here, we have considered short
term capital gains and a period of one-year investment for simplicity, but the
same tax efficiency is applicable for long term (over 3 years) investment in
debt funds.
[Note on taxation: If you sell units of Debt fund within 3 years, capital gains on
debt funds are treated as short term. It will be added to your income and taxed
as per your applicable tax slab.]
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