To outline why debt funds are more tax-efficient than your fixed deposits, you first need to understand their definition. Let’s learn further about them in a nutshell through the given narration.
Put simply; deft funds are the mutual funds that invest in debt securities. A majority of debt funds have greater exposure to government securities. However, they may even take exposure to the institutional or private debt in order to achieve higher returns.
In India, retail investors think that bank fixed deposits are a stable investment over the last few decades. And banks are referred to as the blue-chip institutions, and with bank FDs, there’s a minimum risk factor.
Why are the debt funds more appreciated among Indian retail investors?
There are two things altering drastically and that point out the importance of debt mutual funds over FDs:
- Firstly, the interest rate has been falling ever since 2015 (inflation at 1 to 2% has caused the rates to only go down further)
- Next, investors are unable to make any profit with interest rates shifting downward in this market
That’s where the debt funds come into being.
On average, the debt funds offer an annualized return of around 10 to 12% based on the invested fund. As a debt fund investor, one needs to earn that interest on the bonds and earn capital gain as soon as the bond price goes up.
One quick note: The bond price will only rise with the reduction in the interest rate.
In addition, the debt funds are liquid & may get monetized at short notice. However, the most terrific advantage that favours debt funds is the tax treatments. Here’s pointing down the details why online mutual funds investment in India is a better solution.
Treatment of the interest achieved via FDs & dividends on the debt mutual funds
Besides the lower rate of interest, fixed deposits have an additional downfall considering the tax. The interest on the banks for FDs gets treated as the regular wage in investors’ hands. Thus, it gets taxed at the tax’s peak rate.
Suppose you’re in 30% of the tax bracket & the bank pays around 8% of interest. In such a case, the post-tax yield on FDs will become 5.6% upon adjusting the tax. That’s enough to cover the risks of inflation, especially in India.
On the contrary, the dividends paid out by debt funds are tax-exempt in the investor’s hands. Indeed, one may argue that the debt funds must withhold the tax on dividend payouts. However, even upon considering the impact, the effective returns for the debt fund holders are much higher.
Understanding what exactly is accrual strategy in the debt funds
You focus on earning an interest income from the debt funds & hold papers until it gets matured under the debt funds’ accrual strategy. The fund managers always follow the accrual strategy in the fixed income instruments of medium or short-term maturity. It’s primarily a buy & hold tactic where the instruments in a portfolio get held until maturity.
The accrual funds are the debt mutual funds that aim to earn the interest income from coupons offered by the securities in a portfolio. Nonetheless, the accrual funds might obtain a return from the capital gains as a small portion of the return.
The TDS deduction on the interest payments
If the bank FD offers the interest, the TDS or tax deduction at the source gets applied automatically. Note that in such a scenario, the interest offered to the individual must be more than Rs. 10,000 every year. Indeed, the TDS is the accounting adjustment, but it creates logistical and procedural hassles for any investor.
Let’s take an example here. When the individual is not coming under any taxable bracket, they may require submitting the form 15G/15H to their bank. In case the TDS gets deducted, the individual requires filing the returns. And then, he needs to claim his refunds from the income tax section.
In each way, the procedure becomes a bit complex, given that a solid chunk of demand for the bank FDs appears from the retired pensioners and persons. The debt funds, on the contrary, are never subjected to the tax deduction at the source. In addition, the TDS question on the debt fund dividend is just applicable only in the case of the NRIs.
Treatment of the capital gain
It’s another area where the investor requires understanding in accordance with the debt funds and FDs. There’s absolutely no question of the capital gains in the case of FDs because they get redeemed at face value. Nonetheless, the capital gain might be a question in the case of debt funds. The debt funds get treated as the non-equity financial asset for calculating the capital gains.
That results in the cut-off for the classification as the long-term capital gains are around three years in the case of any debt fund. When the debt funds get sold within a span of three years, it gets classified as the short-term capital gain & taxed at a high rate. When the debt fund gets held for more than three years, it is long-term. And it gets taxed at 20% upon considering indexation benefits.
Nonetheless, most debt funds pay out profits as dividends – more tax efficient. So, it explains why a majority of investors always choose the dividend plans when it’s about debt funds. There might be one thing to say in favour of the FDs in banks.
When the investor parks money in the long-term FD with the bank, they get an additional advantage of the exemption to around 1.5 lakh that might be available on the investment under Income Tax Act 80C. But considering the Income Tax Act 80C, the equity schemes offer more profitable processes of saving the tax.