Why debt funds are more tax efficient than bank FDs?

Debt funds are mutual funds that invest in debt securities. While most of the debt funds have a large exposure to government securities, they also take exposure to private and institutional debt in the quest for higher returns. For Indian retail investors, bank FDs have been a stable investment for the last many decades. Banks have been blue-chip institutions and therefore the risk has been almost negligible in bank FDs. But two things are changing that is beginning to make a case against banks FDs. Firstly, the interest rates have been falling consistently since the beginning of 2015 and with inflation at around 1-2%, rates are only likely to head further down. Lower rates have resulted in lower yields on bank FDs. Secondly; investors do not make any profit when interest rates shift downward in the market.
 
That is exactly where debt funds fit in. Debt funds, on an average, offer annualized returns in the range of 10-12% depending on the fund you are invested. As an investor in debt funds you not only earn the interest on the bonds but also earn capital gains when the price of bonds goes up due to a fall in interest rates. Additionally, debt funds are extremely liquid and can be monetized at very short notice. But the biggest advantage favouring debt funds is the beneficial tax treatment vis-a-vis bank FDs. Let us understand this in greater detail..
 
Treatment of interest earned on FDs and dividends on debt funds
Apart from paying lower interest rates, FDs have the additional disadvantage on the tax front. Interest on bank FDs are treated as regular income in the hands of the investor and therefore will be taxed at your peak rate of tax. So if you are in the 30% tax bracket and your bank FD pays you 8% interest, then your post-tax yield on the FD will be only 5.6% after adjusting for tax. That is hardly enough to cover the risk of long-term historic inflation in India. The dividends paid out by debt funds, on the other hand, are entirely tax exempt in the hands of the investor. Of course, one can argue that debt funds are required to withhold tax on dividend payouts but even after considering that impact the actual effective returns for debt fund holders is relatively much higher.
 
Deduction of TDS on interest payments
When a bank FD pays out interest then the tax deduction at source (TDS) is automatically applied if the total interest paid to an individual is in excess of Rs.10,000 per annum. Of course, the TDS is only an accounting adjustment but it does create procedural and logistical hassles for the investor. For example, if the person is not coming under the taxable bracket then they will have to submit Form 15G/15H to the bank well in advance. If the TDS gets deducted then the person has to file his returns and then claim the refund from the income tax department. Either ways, the process becomes quite complicated especially considering that a good chunk of the demand for bank FDs comes from retired persons and pensioners. Debt funds, on the other hand, are not subject to TDS on dividends paid out since dividends are anyways tax-free in the hands of the investor. Of course, the question of TDS on debt fund dividend is only applicable in case of NRIs.
 
Treatment of capital gains
This is one more area an investor needs to understand with respect to both bank FDs and debt funds. Of course, there is no question of capital gains in case of bank FDs as such FDs are always redeemed at face value. However, in case of debt funds there is a question of capital gains. Debt funds are treated as non-equity financial assets for the purpose of capital gains calculation. As a result the cut-off for classification as long term capital gains is 3 years in case of debt funds. If debt funds are sold within 3 years of purchase then it will be classified as short term capital gains and taxed at your peak rate of tax. If the debt fund is held for a period of more than 3 years then it becomes long term capital gains and will be taxed at 20% after considering the benefit of indexation. However, practically most debt funds prefer to pay out the profits in the form of dividends being more tax efficient. That explains why most investors prefer the dividend plans when it comes to debt funds. There must be one thing said in favour of bank FDs here. If an investor puts money in a long term (5-year) term FD with a bank, then the additional benefit of exemption up to Rs.150,000 will be available on this investment under Section 80C of the Income Tax Act. However, if Section 80C is your intent then equity ELSS schemes offer a more profitable way of saving tax as compared to long term bank FDs.
 
Apart from higher returns and liquidity, tax treatment is a major case favouring debt funds over bank FDs. As interest rates trend downwards, the time to make the shift may be now!