I was curious to know if it makes more sense to park excess cash in Ultra Short term debt funds rather than the traditional savings bank accounts. These funds seem to have no entry and exit loads and offer relatively higher returns in comparison to the 4% offered by savings accounts. Is there anything (related to taxation etc.) I am missing here or would you advise me to park the excess money in these debt funds?
You are right. Ultra short term debt funds do offer better returns than a savings account with a bank, because they are actively managed to take advantage of spikes in short term rates and can invest in corporate and money market instruments. But do note that they carry some risk. Returns on ultra short term funds in the last one year have been exceptionally high due to the high interest rate regime. The category gave a 9 per cent plus return. Going forward, as rates fall, the returns will fall, though they may still be higher than 4 per cent.
Ultra short term funds suffer higher tax incidence than savings accounts. Interest of upto ₹10,000 from savings accounts is exempt from tax. But returns from debt funds (by way of NAV gains) if held for less than 36 months are taxable at your slab rate (10,20,30 %). This applies if you go for the Growth option. The Dividend option suffers Dividend Distribution Tax at 28.33 % too.
The following illustration shows the net income, an investor may receive in an Ultra Short term funds versus savings bank accounts based on assumed returns. We have assumed the savings account interest rate to be 4 per cent and the return from ultra short term debt funds at 8 per cent. Also, the tax slab is taken as 20 per cent.
|Savings Account||Ultra short term debt fund|
|Net Taxable Income||6000||32000|
|*Interest earned from savings account is eligible for a deduction upto 10,000.|