It makes sense to invest in FMPs during the concluding months of a financial year...
28-Mar-2011 •Larissa Fernand
I have been told that it is a good time to invest in FMPs right now. Why is that so? Also, is it a better avenue than a bank fixed deposit?
- Sandeep Bhatia
There are two reasons for the popularity of fixed maturity plans (FMPs).
Short-term rates have hardened significantly because of the ongoing liquidity tightness in the market. Hence a lot of the short-term instruments such as Certificates of Deposit (CDs) are being offered at high rates. This will not last forever so there is an opportunity to capture this anomaly through an FMP.
Secondly, towards the end of a financial year, fund houses tend to come out with many FMPs simply to make use of indexation benefits. Let me elaborate.
FMPs have the same tax structure as debt-oriented mutual funds. If they are sold within a year of purchase, short-term capital gains tax will be charged based on the existing tax slab of the investor. If they are sold after one year, it will be treated as long-term capital gains and the tax rate will be 10 per cent without indexation or 20 per cent with indexation benefits.
A big carrot used in the case of FMPs is the benefit of double indexation if the schemes overlap two financial years. Let's suppose you invest in an FMP in March 2011 which will mature on April 2, 2012. This period of investment would be just above a year. However, you made the investment in FY2010-11 and sold it in FY2012-13. As a result, you reap the indexation for two years (2011-12 and 2012-13). Naturally your tax outgo will reduce. Hence it makes sense to invest in FMPs during the concluding months of any financial year.
But does it make sense to opt for an FMP which matures after April 1, 2012 when the Direct Tax Code (DTC) comes into effect? Under the DTC, double indexation is unavailable.
Indexation takes inflation into account while calculating the asset's cost of acquisition. Inflation is calculated by using the cost inflation index (CII) which is put out by the government every year. Under the Income Tax Act, the indexation factor is calculated by dividing the CII in the year of maturity with the CII in the year of purchase. The DTC proposes to replace the denominator with the CII of the financial year following the year of purchase of FMP (see: Income Tax Act v/s Direct Tax Code). So essentially, it's single indexation, not double indexation.
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How it scores against a fixed deposit
• With a fixed deposit you are assured of a fixed return at the end of the tenure. There is no such assurance in the case of an FMP, though the tenure is fixed.
• Should you want to break your fixed deposit, the bank will allow it if you pay a penalty. You can even get an overdraft/loan on the amount invested. No such facility exists for an FMP. Though an FMP is listed on a stock exchange, it is a fairly illiquid product since there is not much of a secondary market.
• In the case of fixed deposits, the return is treated as income from 'Other Sources' and the normal tax slabs apply. This is irrespective of the tenure of the deposit. So for an investor in the 30 per cent tax bracket, instead of paying such high tax on the interest earned, he can invest in an FMP and pay either 10 or 20 per cent.
• However, a senior citizen who does not fall in any tax bracket would do well to invest in a bank fixed deposit since the returns right now are very appealing and assured.
