Bank FDs vs Debt Mutual Funds: Which is the Most Tax-Efficient Investment?

Nov 22, 2022 / Reading Time: Approx. 9 min

Listen to Bank FDs vs Debt Mutual Funds: Which is the Most Tax-Efficient Investment?

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The Indian financial market offers a wide variety of investment opportunities. There are investments across time frames, from as short as one week to as long as 10 years or more. Similarly, there are also different options for investors with different levels of risk appetite. The equities market can be just what you need to concentrate on if you are a risk-taking, aggressive investor. However, if you are a more conservative investor, you should consider investing in fixed-income investments and safer assets that are less volatile.

Two of the most preferred investment options for risk-averse investors are fixed deposits and debt mutual funds. Let us take a closer look at these options.

Fixed Deposits (FDs) have been one of the most popular investment instruments in India for decades now. The majority of Indian households have had their financial wheels churned by bank fixed deposits. However, with the change in times and the financial environment, a lot of investment trends have evolved. Due to the drop in FD interest rates in the past few years, there has been a noticeable shift into debt mutual funds. Although Debt mutual funds are not as widespread as equity mutual funds among retail investors, they still have recently attracted increasing attention.

Given that, Fixed deposit vs debt mutual fund has been a contentious topic for every investor. When we compare a bank fixed deposit with a debt mutual fund, we can see that there are many things that set them apart, like their features, the time frame they are invested for, etc. This is why prior to making an investment in either, it is crucial to comprehend the differences between the two.

In order for you to make an informed investment decision, let's examine the main distinctions between investments in fixed deposits and those made by debt mutual funds.

Bank FDs vs Debt Mutual Funds: Which is the Most Tax-Efficient Investment?
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Key differences between Bank FDs and Debt Mutual Funds:

  • Risk

    Upon risk comparison of bank fixed deposit vs debt mutual funds, the banks have been blue-chip institutions and therefore the risk has been almost negligible in bank FDs and are categorised as a risk-free investment.  You will receive interest income at the rate of interest guaranteed on your fixed deposit. Even if the bank defaults, deposits are covered by insurance from Deposit Insurance and Credit Guarantee Corporation (DICGC) under RBI insurance to the extent of Rs 5 lacs

    On the contrary, mutual funds are marked-to-market products and are hence impacted by changes in interest rates and credit spreads. However, due to the possibility that the interest rates on the fixed income securities may change depending on the interest rates in the economy, debt mutual funds have a slightly higher risk. Comparatively, this risk is still far lower than the risk on equity funds. Debt mutual funds usually invest in securities with high credit ratings and a strong track record. Investors, therefore, should always check the credit ratings of bonds and debt instruments where the mutual fund is investing.

  • Flexibility of Investment

    In the case of a fixed deposit, you need to make a lump sum investment at the beginning of the investment tenure. However, with debt mutual funds, you have the option of investing a lump sum in the scheme, or you can invest small amounts periodically via a Systematic Investment Plan (SIP). 

  • Additional Charges

    Fixed deposits generally do not come with any additional charges. But debt mutual funds may come with nominal additional charges like fund management charges, which are levied by fund managers to handle your investments, and exit load, which is levied when you exit the mutual fund scheme.

  • Liquidity

    In comparison, both Bank FDs and debt funds are fairly liquid, and the investment can be accessed anytime. However, depositors who intend to withdraw must break their fixed deposit and pay the penalty for doing so during the early withdrawal period. In the case of debt mutual funds, if you withdraw before the specified time, you will be charged a 1% exit load. You can redeem units for free after the specified exit load time. Some debt funds, such as overnight funds, do not charge an exit fee. Notably, Liquid funds have high liquidity, and you can easily redeem them as compared to other debt funds.

  • Effect of Inflation

    As key policy rates are used to control inflation by the policymakers, Repo rate, Reverse Repo rate, and the resultant overall interest rates on deposits and lending may vary with the rate of inflation.

    Consequently, to generate risk-adjusted inflation-beating returns, the interest rate paid on FDs and the annual return or CAGR on debt mutual funds should be near to the rate of inflation. However, in case the rate of inflation exceeds the interest rate regime, the money invested in FDs would lose its purchasing power, i.e., the real return on FD will turn negative. So, FDs are considered as inflation inefficient instruments.

    On the other hand debt mutual funds may somewhat absorb the effect of rise in inflation rate, as the debt instruments may be traded in secondary markets. Moreover, indexation benefit is available while calculating long-term capital gain (LTCG) on debt funds, which makes such funds inflation efficient.

  • Returns

    While the return on a bank FD is fixed and there is a fixed maturity amount, with fixed maturity instruments in its portfolio, the return on a debt fund may also be quite stable and predictable. However, as the debt instruments in a debt fund's portfolio may be traded on secondary markets, the fund's Net Asset Value (NAV) may change, producing returns that are higher or lower than those produced by the fixed-return instruments in the portfolio.

    When actively managed, mutual funds have the potential to produce returns that are higher than those provided by bank deposits. The fund manager can actively increase the duration and/or take credit risk depending on his view of the macroeconomic situation and can position his fund to benefit from his expectations playing out - either through interest rate changes or change in credit spreads. In case interest rates soften, liquid funds can deliver returns higher than the portfolio yield, and vice versa. FD rate of return stays the same throughout its tenure.

    For risk-averse investors, fixed deposits and debt mutual funds are among the most popular investments. Fixed deposits have proven to be a reliable option for Indian retail investors despite rising interest rates, and Debt funds generally offer superior annualised returns than FDs. Debt funds have somewhat higher yields ranging from 7-9% as opposed to FDs' 6-8%, despite being the risky alternative to FDs. However, there are notable tax differences between debt funds and fixed deposits.

Tax Implications of Bank FDs vs Debt Mutual Funds:

How are Bank FDs taxed?

One earns Interest Income from FD's, which is taxed as per the Income Tax slab rates. However, no tax is levied on the maturity proceeds of a Bank FD. The bank will deduct TDS at 10% if the interest amount paid to a resident individual on FD exceeds Rs. 40,000 (Rs. 50,000 in the case of a senior citizen). So if you are in the 30% tax bracket and your bank FD pays you 7% interest, then your post-tax yield on the FD will be only 4.9% after adjusting for tax. That is hardly enough to cover the risk of long-term historic inflation in India.

How are Debt Mutual Funds Taxed?

The holding period for debt mutual funds affects how much tax is payable. Debt-oriented mutual funds held for up to 36 months or 3 years are classified as short-term capital gains under section 2(42A) of the Income Tax Act, 1961, and are subject to the investor's marginal slab rates of taxation. On the other hand, after taking advantage of indexation, units held for more than 36 months are subject to long-term capital gains tax at 20% with indexation benefits under Section 112 of the IT Act. Further, any dividend derived from the debt mutual fund is taxed as per the marginal slab rates applicable to the investor.

To conclude...

The tax-efficient option for any investor would depend on a number of variables, including the return on the investment, the applicable tax bracket, nature and time period of holding (for example, cost indexation benefit available in case of long-term debt mutual funds), FD interest deduction up to Rs. 50,000 is available u/s 80TTB for senior citizen, etc.

A fixed deposit is your investment choice if you value capital security and assured returns. In contrast, investing a portion of your fixed-income assets in debt mutual funds could result in potentially higher risk-adjusted returns while also providing tax benefits. In a macroeconomic environment that is continuously changing, debt funds outperform FDs. They offer better benefits for investors in higher tax slabs while offering marginally higher returns with comparable risk levels. Therefore, it is prudent to make investments in worthy avenues as per your suitability to generate better risk-adjusted returns.


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Warm Regards,
Mitali Dhoke
Research Analyst

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