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The tax advantage

Savers would do well to understand the working of the tax advantage that mutual funds have over bank deposits

The tax advantage

A couple of months ago, I had written in these pages an article on replacing bank fixed deposits with fund investments. However, a lot readers don't understand the exact mechanism by which funds attract less taxation, so here's a detailed explanation of the entire issue. In three years, falling interest rates have knocked off about 40 per cent from the annual income that a fixed deposit would give you. That's a shocking decline. People generally don't do the maths of returns correctly. Each step in the decline of the fixed deposit rate appears small, generally around 0.25 to 0.5 per cent. That sounds trivial.

However, the actual reduction in income is much more. For example, a decline in the interest rate from 7.5 to 7 per cent is is a reduction of 7 per cent in the income that the deposit generates. This adds up fast. Over the last three years, you would have seen a reduction from 8.75 per cent to 6.25 per cent in the rate of interest that you earn from your fixed deposits. That's a reduction of 40 per cent in the actual income.

The logical way to mitigate this problem is to shift money from fixed deposits to mutual funds. Mutual funds that have a low risk profile that would appeal to fixed deposit holders have rates of return that appear to be (just like the above example) marginally more than fixed income. However, the maths works the same way. Over the last year, a fixed deposit would have yielded 7 per cent interest, which was about the rate in late 2016. Over the same period, an average liquid fund (which has negligible risk and variability) would have yielded 7.5 per cent. That's a 10 per cent higher earning.

However, on top of that is the icing on the cake, which is taxation. For investments less than three years, the taxation is the same on the two options. If you sell off the entire mutual fund investment, then the earnings will indeed be taxed at the same rate as the fixed deposit by just being added to your income. However, if your goal is to withdraw the gains, then the tax paid in mutual funds on that withdrawal is much less. The reason is simple. Interest is income, while mutual fund returns are capital gains. When you receive income from a deposit, the entire thing is income. However, when you withdraw money from your mutual fund investment, a part of it is the original principal you invested, which is obviously tax-free.

Here's a concrete example. Let's say you invest Rs 10 lakh in a mutual fund. A year later, the value of the investment has increased to Rs 10.80 lakh. Now, you want to withdraw the Rs 80,000 you have gained. Note that in the investment you hold, 7.4 per cent is the gain and the rest (92.6%) is the principal that you had invested. Here's the key part: when you withdraw any money, the withdrawal shall be deemed (for tax purposes) to consist of the gains and the principal in this same proportion. Therefore, of that Rs 80,000, only Rs 5,926 will be considered gains and will be added to your taxable income. This makes a gigantic difference. In an equivalent fixed deposit, you would pay Rs 24,720 as tax in the top slab. In the mutual fund, you would pay Rs 1,831 as tax.

There are other benefits which fund investors understand but bank depositors seem to be unaware of. There's TDS and annual taxation, for example. For cumulative fixed deposits, tax has to be paid every year. That's money that won't be earning returns in the future. In the equivalent mutual fund investment, there's no annual tax liability (since the gains are not income) so the money is available for compounding for as long as the investment is held. After three years, the accumulated amount in the mutual fund will be almost one and a half times that in the FD, assuming you are in the top tax bracket. For an initial investment of Rs 1 lakh, at the end of three years, the FD will effectively be worth Rs 1.26 lakh while the fund investment will be worth Rs 1.4 lakh. Since the FD tax outgo is split between 10 per cent TDS and the rest paid out directly, the exact rate of return depends on how you account for this tax.

Any which way you look at it, in these times of falling interest rates, the tax advantages make the mutual fund alternative doubly attractive.