Tax impact: investing in mutual funds vs Bank FD

Bank Fixed Deposits (FDs) are one of the most popular traditional investment schemes in India. However, FD interest rates have fallen over the past years and at the same time, mutual fund investment has become a popular investment instrument. So, which investment is better for tax saving? Read on to find out.

Tax impact of bank FDs:
 

1. The income earned on the interest earned by bank FDs is fully taxable according to their income tax slab. So, Kiran who earns Rs 70 lakh a year has to pay 30% income tax on the income earned on her bank FD. Shaila, who earns Rs 7 lakh a year, has to pay 20% income tax on her bank FD’s interest income.
    
2. Tax deducted at Source (TDS) is 10% if the interest income exceeds Rs 40,000 per annum or Rs 50,000 in the case of senior citizens.
   
   However, there is a tax benefit upto Rs 50,000 for senior citizens for interest earned in savings bank account as well as fixed deposits in banks and post office under section 80TTB. This is not applicable to Indian residents less than 60 years of age.
    
3. If investors do not submit their PAN card, then the TDS rate is increased to 20%.
    
4. There is no TDS if the investor’s overall income earned is less than the minimum taxable amount.
   
   Suppose your bank FD earns an interest income of Rs 40,000, but the total income is below Rs 2.5 lakh; you will not be charged TDS. But to ensure you are not charged TDS, you must submit Form 15G and Form 15H to your bank.
    
5. There was a time when bank FDs earned interest rates as high as 8–9% and even higher for senior citizens. However, that has changed drastically and bank FDs no longer offer such high interest rates. Each decline in FD interest rate may seem minimal but the impact on the annual income earned is huge.
   
   This is because the income tax charged on bank FDs earned income eats away at the interest income earned on bank FDs. Here is a table illustrating how taxpayers’ income tax lowers the effective interest rate of FDs.

Tax impact of mutual funds:
 

• Mutual funds earn two types of income—dividends and capital gains or loss when selling fund units. Both types of income have tax implications.
• Mutual fund taxation also depends on whether it is a debt or an equity mutual fund.
• Dividends earned by mutual funds are taxable according to the taxpayer’s income tax slab.
• Equity mutual funds are those that hold over 65% of their portfolio in equity investments. If an investor redeems their fund units within a year, they would be subject to Short-Term capital gains (STCG), if any. STCG has a flat tax rate of 15% regardless of the investor’s tax slab.
• Equity funds held for over a year are subject to Long-Term capital gains (LTCG) tax. LTCG below Rs 1 lakh is tax-free. However, LTCG exceeding Rs 1 lakh is taxed at 10% plus cess and surcharge. There is no indexation benefit.
• Debt mutual funds are those with 65% and above of their portfolio in debt instruments. Here, STCG tax is charged if units are sold within 36 months (three years). STCG is charged as per the investor’s tax slab. LTCG tax is charged on funds held for over 36 months at a flat rate of 20% after indexation. Cess and surcharge on tax are also applicable.

Summing up:
 

Although bank FDs are traditionally viewed as safe investments, they may not be the better choice. Reduced interest rates, plus TDS and the income tax charged mean that investors gain very little from their FDs. Mutual funds are riskier but offer much better returns and better tax benefits. Thus, mutual funds are a more attractive investment compared to bank FDs.