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Your Questions Answered: What are the comparisons and differences between FDs and debt mutual funds?


Q. I am a civil engineer working with one of the largest private construction companies in India. My wife is also a civil engineer working as an independent consultant. We are both in the top tax bracket. We have been investing in debt mutual funds for the past 10 years. However, we now understand that after the 2023 budget the tax benefits associated with the debt mutual funds have been withdrawn. Can you please elaborate on the same? We are now thinking of investing in fixed deposits. Can you please compare and contrast investing in fixed deposits with investing in debt mutual funds?

In the field of financial planning, the choice between debt mutual funds and fixed deposits (FDs) is still a common area for investors. Both instruments act as savings stores, offering different levels of risk, return and liquidity. A thorough understanding of their nuances is critical to making informed investment decisions.

Budget 2023

Debt mutual funds have been considered a tax-efficient investment option due to favorable long-term capital gain (LTCG) tax treatment. Gains from debt funds held for more than three years were taxed at a concessional rate of 20% with an indexation benefit, allowing investors to adjust their cost base for inflation. This made debt mutual funds more attractive compared to bank fixed deposits (FDs), where interest income taxed at the individual’s applicable tax slab.

Changes introduced in Budget 2023

Budget 2023 removed the LTCG tax benefits from debt mutual funds. This means that gains from these funds, regardless of holding period, are now taxed at the investor’s applicable tax slab, similar to short-term. capital gains. The benefit of indexation has also been withdrawn for these funds.

Impact of the changes

Due to the removal of LTCG tax benefit, the tax attractiveness of debt mutual funds as compared to FDs has decreased. Investors in these funds will now face higher taxes on their gains, especially those in the highest tax brackets. This may result in a shift of investments from debt mutual funds towards FDs or other tax saving instruments. The new tax regime applies to investments made in debt mutual funds on or after 1 April 2023. Investments made before that date will continue to be criticized under the old rules.

Differences between FDs and debt mutual funds

There are many differences between FDs and debt mutual funds. We’ve covered the main features below:

Risk: Fixed deposits are considered low-risk investments, as they offer a guaranteed return on investment (ROI) for a predetermined period. The investor’s principal remains safe, protected from market fluctuations. In contrast, debt mutual funds have a slightly higher risk profile due to their exposure to interest rate movements. However, the risk associated with debt funds is generally considered moderate compared to equity investments.

Working: Fixed deposits involve locking up an amount of money for a fixed tenure, from a few months to several years. The investor earns a predetermined interest rate on the deposited amount, which is paid out periodically or at maturity. In contrast, debt mutual funds pool money from multiple investors to invest in a portfolio of debt instruments such as bonds, treasury bills and commercial paper. The fund manager actively manages the portfolio, with the aim of generating returns that outperform the benchmark index.

Returns: Fixed deposits tend to offer lower returns compared to debt mutual funds. However, it is relevant to note that the interest rates offered on fixed deposits have been rising recently, therefore many fixed deposits are offering returns that are comparable and in many cases better than those withdrawn usually out through low-risk debt mutual funds. Interest rates offered by banks are often influenced by wider economic conditions and may change over time. On the other hand, debt mutual funds have the potential to generate higher returns due to their dynamic nature and exposure to various debt instruments. However, the returns from debt funds are not guaranteed and may change depending on market conditions and the performance of the fund manager.

Taxation: Taxation of debt mutual funds differs from fixed deposits in certain aspects. Interest earned on fixed deposits is taxed according to the investor’s income tax slab. As detailed above the capital gains on debt mutual funds are also taxed as per the investor’s tax slab after budget 2023. However, it is important to note that in case of tax saving fixed deposits, the investment in the tax-. saving of fixed deposits is exempt from tax under Section 80C of the Income Tax Act, up to a limit of 1.5 lakh per annum. No such tax exemption is available in case of debt mutual funds.

Frequency of returns: Fixed deposits provide a fixed rate of interest, paid out periodically or at maturity. On the other hand, debt mutual funds are very liquid and can usually be sold at any time, but it is important to note that most investors keep their investment in debt mutual funds for a a long period of time.

Liquidity: Fixed deposits are less liquid than debt mutual funds. Penalties are usually charged for early withdrawals from fixed deposits, and the investor may not receive the full amount deposited. On the other hand, debt mutual funds offer higher liquidity. Most debt mutual funds allow redemptions at any time, and the proceeds of the redemption are usually credited to the investor’s account within a few days.

The choice between debt mutual funds and fixed deposits depends on the risk tolerance, investment horizon and financial goals of the individual. Fixed deposits offer the security of guaranteed returns and are suitable for investors looking for low-risk options. Debt mutual funds have the potential to generate higher returns but also carry slightly higher risk. Debt mutual funds may be a more attractive option for investors with a longer investment horizon and moderate risk appetite.

Finally, a thorough understanding of the characteristics and nuances of both debt mutual funds and fixed deposits is essential to making informed investment decisions. Investors should carefully consider their risk tolerance, financial goals and investment lease before choosing between these two instruments. A consultation with a financial advisor can provide valuable guidance and help tailor an investment strategy to individual needs and preferences.

Cover is a free mutual fund investment platform.

Note: This is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.

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Updated: 17 November 2023, 08:48 AM IST

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