Joydeep Sen
Two deployment avenues are to be compared on the parameters of safety, liquidity, returns, ease of access, etc. Apart from these, another relevant aspect is tax efficiency i.e. for comparable risk-return profile investments, net-of-tax return expectation may be considered for comparison.
Bank deposits and fixed income mutual funds differ with each other on a key parameter. Bank deposits have ‘contractual’ returns i.e. the returns are known upfront and would not vary. Mutual funds are market-driven investments, dependent on movements in the underlying market. Having said that, liquid funds, though theoretically market-driven, are stable in performance with negligible mark-to-market movements. In that sense, liquid funds are comparable with bank deposits.
Returns from bank deposits, either savings or term, are taxable as interest at your marginal slab rate. The marginal slab rate for most investors would be 30 percent, which is the bracket for income more than Rs 10 lakh per year. On top of it, there is a surcharge of 10 percent / 15 percent applicable if you earn more than Rs 50 lakh / Rs 1 crore per year. Not to forget, there is a cess of 3 percent. Hence, in the income bracket of Rs 10 to 50 lakh, the tax rate is 30.9 percent and for people earning more than Rs 1 crore per year, the rate is 35.5 percent. However, if you are in a lower tax bracket of 5 percent or 20 percent, you pay a lower tax on your bank deposits.
In mutual funds, there are two options, dividend and growth. In the dividend option, there is a dividend distribution tax (DDT), which is deducted by the asset management company (AMC) on behalf of the investor and submitted to the government. The dividend received by the investor in a liquid fund or a debt fund is tax free in his/her hands, but comes after DDT, irrespective of the tax bracket of 5 percent or 20 percent or 30 percent. The DDT rate for individual investors, in liquid / debt funds, is 28.84 percent. Hence, if you are in the highest tax bracket (30 percent plus), mutual funds are slightly more tax efficient over bank deposits. If you are in a lower tax bracket (5 percent or 20 percent) then apparently bank deposits are better, but there is a way out, discussed below.
In the growth option of mutual funds, the gains are taxable in the hands of the investor, as per the marginal slab rate, for short-term capital gains, defined as a holding period of up to three years. So, if you are in a lower tax bracket (5 percent or 20 percent) it is advisable to opt for the growth option of mutual funds because DDT rate is 28.84 percent irrespective of your tax slab. One additional tax benefit possible in growth option of mutual funds is that of set-off.
Short-term capital gains can be set off against short-term capital losses. Hence, if you have any short-term capital loss, it can be used to set off your short term capital gains from mutual fund investments, which is not the case with bank deposits. For guidance on short-term capital losses, you may consult your chartered accountant.
Now, let us look at a case of net of tax returns in bank deposits vis-à-vis liquid funds. The assumptions are (a) for a tenure of less than 7 days return from bank is 4 percent as fixed deposits are for 7 days and longer (b) for 1 month, return from bank is 5.5 percent and (d) return from liquid fund is 6 percent.
As we see in the table above, as the amount of investment and period of investment goes up, the utility of liquid fund over bank deposits goes up accordingly. The differential becomes more significant if (a) the comparison is with bank current account where there is no interest or (b) growth option of mutual fund where the investor has a tax set-off.
After SEBI allowed fund houses to provide instant redemption in liquid funds up to Rs 50,000 or 90 percent of folio value, to individual investors, retail investors can use the mutual fund route more efficiently. Even otherwise, you get your redemption proceeds on T+1 day i.e. the day after you submit the redemption request, at the NAV of previous day. The proceeds usually come in the morning of T+1 day so that you are in a position to deploy the money i.e. there is no loss of one day’s earning in the MF route.
(Author is an independent financial advisor)
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