While the FD rates are failing to keep pace with the rate of inflation, investors end up paying tax on interest earned as well, resulting in even lower return on maturity.
Hit by high inflation and low fixed deposit (FD) interest rates offered by banks, FD investors are a worried lot as money invested in bank FDs are losing purchasing power. This is because while the FD rates are failing to keep pace with the rate of inflation, FD investors are ending up paying tax on interest earned as well, resulting in even lower return on maturity.
For example, at the current inflation rate of over 7.5 per cent, Rs 1 lakh invested should become Rs 1,43,563 to keep the same purchasing power intact after 5 years. However, at around 7 per cent rate, an FD investor falling in the 30 per cent tax bracket would get Rs 1,40,255 on maturity, but end up paying 30 per cent tax on the gain of Rs 40,255, which would be around Rs 12,076.
So, at the end of the 5-year investment period, the maturity value of Rs 1 lakh invested in FD would be Rs 1,28,179 for an investor in 30 per cent tax bracket. In the process, the money invested in FD by the investor would lose Rs 15,385 in purchasing power.
So, the question is, what the investor should do to stop or minimise the loss in purchasing power without sacrificing the liquidity?
One of the options is investing in debt mutual fund (MF), as the investor would get the indexation benefit, which becomes applicable on long-term capital gain (LTCG), when debt funds are redeemed after 3 years from the date of purchase. On debt fund LTCG, an investor needs to pay 20 per cent tax after indexation.
In the above case, if the same rate of inflation, rate of return (CAGR), investment value and investment period is taken, the maturity value on the investment of Rs 1 lakh would be Rs 1,40,255 after 5 years, while the indexed cost/value of Rs 1 lakh over the same period would be Rs 1,43,563. So, after indexation, there will be long-term capital loss (LTCL) of Rs 3,308, on which the investor doesn’t have to pay any capital gain tax, but may adjust the LTCL against any LTCG on any other MF.
So, by investing in a debt MF, the investor would end up losing Rs 3,308 in purchasing power, as against the loss of Rs 15,385 in case of FD investment.
But considering that, there are 16 categories of debt funds (as mentioned in the table below), which category of fund a FD investor would choose to have similar liquidity and safety?
To graduate from FD to MF, an investor should choose a debt fund having very short duration papers/securities in its portfolio.
Overnight funds invest in shortest duration of papers/securities, followed by liquid funds. Such funds are considered very safe, with high liquidity and rate of returns comparable to that of prevailing FD rates.
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However, to get higher returns, such investors may choose accrual funds with medium yield, with mostly AAA rated bonds in the portfolio having higher safety and medium yield and some bonds with AA rating to boost the yield.
However, to ensure if the fund is a medium yield fund, an investor should check the portfolio composition before investing or take the help of a financial advisor to decide if such funds would meet your investment objectives.