Growing up with the previous generation always has its pluses and minuses and while the positives well outweigh the negatives, the one negative (which actually at first glance sounds like a positive) is the advice that banks are the best place to park your money and help grow it with interest. In fact, to this day an overwhelming majority of senior citizens diligently chase yield in fixed deposits on a regular basis.
From a financial standpoint, however, keeping your money in a savings or FD account is akin to committing interest rate hara-kiri. Now one may ask why is that the case. FDs currently pay interest rates of around 7% for 1-year deposits. This interest is subject to regular income tax. If we assume an individual in the 30% tax bracket, then the actual after tax return on FDs reduces to 4.9%. India’s CPI inflation is currently at 5.5%, so in essence an FD return doesn’t even beat inflation in real terms.
The numbers worsen further in case of savings accounts, which pays out an interest rate of just 4% well below inflation of 5.5%. For savings accounts, however, a deduction of Rs 10,000 is allowed under Section 80TTA for interest earned in a financial year. The amount earned over Rs 10,000 would be liable to pay tax as per the income tax slab rates.
WHERE TO INVEST
So, that puts us in a conundrum and a quandary when it comes to bank deposits. Where does one invest securely without speculating in the stock market and earn relatively high yields from deposits?
We recommend parking your savings bank money in ultra-short bond funds where the underlying investments are in government and AAA rated securities. Ultra-short bond fund returns range anywhere between 7.5% and 9%, which is higher than savings account interest rates. Innovative products are now available in the market, which allow you to invest your money in ultra-short term bond funds with redemption capabilities within 30 seconds through IMPS. Additionally, some AMCs also provide debit cards linked to investment accounts, which significantly enhances the liquidity of the investment and makes it more akin to a savings bank account.
Short term FD is usually money that one needs after a few months. The ideal thing to do with such money is to move it in to liquid funds or ultra-short term debt funds, which yield 7.5%-9%. Redemptions are generally available within a day and there is no lock-in period unlike FDs.
Long-term FD is usually money that one doesn’t need to tap for a year or more. We recommend moving such funds to short-term bond funds, which yield anywhere between 8-10% with redemption available the next day.
The minimum tenure for long-term capital gains on debt funds is three years. This means that investors will have to remain invested for at least three years if they want the benefit of lower tax on long-term capital gains.
If debt funds are redeemed within three years, the tax treatment is similar to the tax treatment on FDs wherein gains are added to the person’s income and taxed as per the applicable income tax slab. However, if the investor can hold for more than three years, a debt fund will be far more tax-efficient than a FD. In a FD, the entire interest earned is taxed at the rate applicable to the investor. The long-term capital gains from debt funds are taxed at 20% after indexation.
Indexation takes into account inflation during the period that the investment is held by investor and accordingly adjusts the buying price. This can lower the capital gains tax significantly.
Another tax-friendly feature of debt funds is that there is no tax deduction at source (TDS) on the gains. In the case of FDs, if your interest income exceeds Rs 10,000 a year, the bank will deduct 10.3% from this income. If you are not liable to pay tax, you will have to submit either Form 15H or 15G to claim TDS. The other problem is that the income from fixed deposits is taxed on an annual basis.
In debt funds, the tax is deferred indefinitely till the investor redeems his units. What’s more, the gains from a debt fund can be set off against short-term and long-term capital losses you may have suffered in other investments.
One caveat, however, when it comes to debt funds, is the exit load. A debt fund is very liquid since you can withdraw your investments at any time and the money is in your bank account within a day. However, some funds levy an exit fee if the investment is redeemed within a minimum period. The exit load can vary from 0.5% to 2%, while the minimum period can range from six months to up to two years. Check the exit load of the fund before you invest.
Manish Hemrajani is CEO & Co-founder, FinAskus