On the face of it, the difference between the best and the worst fixed income choices is perhaps 1.5 to 2%. That sounds trivial, but over time this makes a big difference. Across a couple of decades, a differential of 2% a year will add up to a differential of more than 50%in the amount you gain. Now you might think that no one invests for 20 years, but that’s not at all true. While a given investment may not last for more than two or three years, most savers always have a substantial amount invested in fixed income options for decades. So this kind of a lost opportunity is a common event, and happens to almost every saver.
Here’s what we almost never realise: the best way to maximise your real, post-tax fixed income gains is to switch from deposits to fixed income mutual funds. Despite the turmoil in certain types of debt funds, the shortest duration debt funds are the safest and offer substantial advantages over fixed deposits. Unlike bank FDs, open-ended fixed income fund investments can be redeemed at a day’s notice without any compromise on returns and investors can start the investment without having to decide what period they are investing for. And, on top of that, over time the funds generally manage to deliver 1% higher returns than fixed deposits. Even with the same tax level, the cumulative effect of these small advantages make them a compelling choice.
Still, the biggest kicker is the tax difference. One reason is lower tax, and the other is TDS. The source of these advantages is that the returns from mutual funds are seen under the tax laws as capital gains. In contrast, the interest earned on deposits is income and is just added to taxable income. Capital gains is taxed when you actually redeem the investment while income is taxed continuously. You have to pay tax every year for the interest you earned that year, just like any income, regardless of whether you have encashed it, or it is still compounding with the deposit. The bank will deduct TDS on this income.
If your total interest income from a bank (all accounts and deposits together) exceeds Rs.10,000 then the bank deducts TDS at 10%. This means that a part of your return is not available for compounding because it is taken out and paid as tax every year. This has a big impact on the eventual returns. But wait, that’s not all! If you stay invested for more than three years, then the capital gains are classified as longterm capital gains and are taxed only after inflation indexation. This does not happen with FDs because the interest is just normal income. Taking into account all these differences, in practice, a threeyear investment even in a very short duration debt fund will mean around double the actual post-tax returns compared to the options. It’s a tragedy that most Indian savers, despite being heavily dependent on fixed income investments, don’t try to get the best out of them.
(The author is CEO, VALUE RESEARCH.)
