India has always been a country with a fixed income investment. For generations, people have naturally depended on PPF, bank deposits, post office deposits, etc. for investment. Such investment does not provide the best return, it is true, but the problem is that we are not able to choose the best option even in fixed income investments.
The best and worst options have a difference of 1.5–2.0% in the Fiscured Income option. People do not pay attention to these things but a difference of 2% per annum can make up to 50% difference in increasing investment in two decades. You would say that no one invests for 20 years but this is not entirely correct. No investment lasts for more than two or three years, but most of the people keep investing huge amount in fixed income option year after year, decade after decade. Therefore, the risk of washing hands with heavy returns as savings remains with everyone.
The best way to get maximum real post tax fixed income gains can be shifting from fixed deposits of banks to fixed income mutual funds. Despite the upheaval in certain types of debt funds, the short-term debt funds remain the safest and provide higher benefits than fixed deposits. They are good in terms of three aspects of investment – return, liquidity and taxation.
Unlike a bank FD, an investment in an open-ended income fund can be redeemed at any time on one day’s notice without compromising returns. Also, investors do not have to decide how long they have to invest. Typically, the returns they receive are one percent higher than fixed deposits that increase over time. Even if you ignore the difference in taxation, small advantages make them attractive.
But the difference in taxation has a profound effect. It is of two types – first low tax rate and second TDS. Combining both, they have a lot of effect. Returns from mutual funds are considered capital gains under the tax law. Conversely, the interest received on deposit is considered and added to the taxpayer’s taxable income. In the case of interest income, the taxpayer has to pay tax on it like every year’s income, whether you have redeemed it or it keeps on depositing.
The bank deducts TDS on this income. If your interest income from the bank is more than Rs 10,000 annually then the bank deducts TDS of 10% on it. This means that you will not be able to get the benefit of increasing the compounding rate on the part of the return, as it is deducted every year as tax. This has a profound effect on the returns received after the investment period. It does not end here. If you remain invested for more than three years, then your gain will be considered as long-term capital gain. Tax will have to be paid only after indexation, which is not in FD, as the interest earned from it is considered normal income.
Keeping all these differences in mind, the actual post-tax return of a three-year investment in a short-term debt fund will be almost double that of the other option. This is tragedy for most savers, who despite investing large sums in fixed income options, do not get the best returns from it.