Why are debt funds better than bank FDs in terms of tax efficiency | Motilal Oswal

Debt funds Vs fixed deposits

There is no dearth of investment options in the Indian financial market. There are investments for different investment horizons, right from as short as one week to as long as 15 years or more. Similarly, there are also different options for investors with different levels of risk appetite.

If you are an aggressive investor who can take on quite a bit of investment risk, the stock market may be just what you need to focus on. But if you are a more conservative investor, you need to consider investing in fixed income investments and safer assets that are not as volatile. 

Two of the most preferred investment options for conservative investors are fixed deposits and debt funds. Let us take a closer look at these options and see how they compare.

What are fixed deposits?

A fixed deposit is one of the most popular traditional investment avenues in India. Your parents and their parents before them may have all had their money safely locked away in bank FDs at some point or the other. 

A fixed deposit essentially allows you to deposit a lump sum of money in an FD account with a bank or a non-banking financial institution, for a specific period of time. Over this period, you earn interest on the amount deposited at a predetermined rate of interest. This interest can either be reinvested into your FD and paid out cumulatively, at the end of the investment tenure, or it can be paid out to you on a monthly, quarterly, half-yearly or annual basis.

For instance, say you invest Rs. 10 lakhs in an FD at an interest rate of 6% per annum. At the end of this tenure, you would have earned an interest of Rs. 8,14,018. And due to compounding, your investment would have grown to Rs. 18,14,018.

What are debt funds? 

Debt funds are relatively newer investment options. They are mutual funds that invest in debt instruments such as government bonds, corporate bonds, money market instruments and other fixed income instruments. 

As in the case of all mutual funds, in debt funds too, the capital from different investors is pooled together. This common pool of funds is then used to invest in the fixed income investments and securities mentioned above. Since debt instruments are less risky than equity instruments, debt mutual funds are ideal for risk-averse investors who want to preserve their capital and earn a fixed, guaranteed income on their investments. 

Debt funds vs. fixed deposits 

Debt funds and fixed deposits may both be suitable for conservative investors, but they have several points of difference between them. Take a look at how they compare in different aspects to make an informed investment decision. 

  • Risk

A fixed deposit has practically no investment risk. You will receive interest income at the rate of interest guaranteed on your deposit. Even if the bank defaults, deposits are covered by DICGC insurance to the extent of Rs. 5 lakhs. 

Debt mutual funds, however, come with a slightly higher risk because the interest rates on the fixed income securities may change based on the interest rates in the economy. This risk, however, is still far lower than the risk on equity funds.

  • Frequency of investment

In the case of a fixed deposit, you need to make a lump sum investment at the beginning of the investment tenure. But in the case of debt mutual funds, you can choose to invest a lump sum in the scheme, or you can invest small amounts periodically via a Systematic Investment Plan (SIP). 

  • Other associated charges

Fixed deposits generally do not come with any additional charges. But debt mutual funds may come with nominal additional charges like fund management charges, which are levied by fund managers to handle your investments, and exit load, which is levied when you exit the mutual fund scheme.

  • Liquidity

Fixed deposit investments are made for a specific tenure. If you want to withdraw your deposit prematurely, the bank will levy a penalty for the same. In the case of debt mutual funds, there is no specific lock-in period. But when you redeem your investments, you may be charged an exit load for the same. Not all debt funds levy this charge though, so check the terms and conditions before you buy the mutual funds.

  • Taxation

The interest earned on your fixed deposit is taxable as per your income tax slab rate. If your total income, including your interest income, is below the basic exemption limit, you need not pay tax on the FD interest. 

As for the gains from your debt funds, they are taxed as capital gains. If you hold the debt funds for 3 years or less, the gains are classified as short-term capital gains and taxed at your income tax slab rate. But if you hold the debt funds for more than 3 years, the gains are classified as short-term capital gains and taxed at 20% (with indexation).

Wrapping up: Which one should you choose?

A fixed deposit may be a good choice if you have a lump sum amount ready for investment, and if you are looking for guaranteed interest income or gains. A debt fund, on the other hand, may be a good choice if you do not have a lump sum amount right now. You can invest small sums - even as low as Rs. 500 - on a regular basis if you start an SIP online. 

But to invest in debt funds, you need to first open a demat account. If you don’t have one yet, you can open one for free on the Motilal Oswal online platform right away and get started with your debt mutual fund investments. 

Related Articles: Investing in Mutual Funds is Now Easy with MO Investor App | Invest In Mutual Funds Online In 5 Simple Steps |  How to Analyse Mutual Funds for Big Returns | Tax Benefits of Investing in Mutual Funds | Mutual Fund - Need of Financial Plan | Upcoming IPO 

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