Bank FD vs Bond Mutual Fund: Taxation

Bank FD & Bond Fund both are fixed income securities. The most ignored part while investing in fixed income securities is the effect of taxation. The blog highlights the differences

Tax Effect on Bank FD

Taxes are paid on accrued interest and payable as per the individual tax brackets.

Ex Mr X invest Rs 10 Lac in a bank FD yielding an interest rate of 6%; Mr X is in a 30% tax bracket; then Mr X has to pay an average tax of Rs 18,000/Annum. The effect of tax over 5 year is as shown below

	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Interest Income	60,000	60,000	60,000	60,000	60,000	3,00,000
Tax Effect	Income	Income	Income	Income	Income
Tax Payable rate	30%	30%	30%	30%	30%
Tax Payable	(18,000)	(18,000)	(18,000)	(18,000)	(18,000)	(90,000)
After Tax Interest Income	42,000	42,000	42,000	42,000	42,000	2,10,000

Tax Effect on Bond Mutual Fund:

Taxes are paid only on redemption/withdrawal and the rates depend on the nature of gain. For Bond fund any redemption within three years is considered as short term capital gain (taxed at applicable individual tax bracket) and redemption after 3 years is considered as long term capital gain (taxed at 20% adjusted for indexation benefit- works out close to 10%)

Ex Mr X invest Rs 10 Lac in a bond mutual fund and decides to withdraw 6% income on yearly basis (to match Bank FD Cash flow) ; Mr X falls in a 30% tax bracket; then Mr X has to pay an average tax of Rs 1,730/Annum. (91% lower than bank FD)

	Year 1	Year 2	Year 3	Year 4	Year 5	Total
Withdrawal	60,000	60,000	60,000	60,000	60,000	3,00,000
Capital Gain (at 6% return)	3,396	6,600	9,623	12,474	15,165
Tax Effect	STCG	STCG	STCG	LTCG	LTCG
Tax Payable rate	30%	30%	30%	10%	10%
Tax Payable	(1,020)	(1,980)	(2,887)	(1,247)	(1,516)	(8,650)
After Tax Interest Income	58,980	58,020	57,113	58,753	58,484	2,91,350

 *STCG-Short term capital gain; LTCG- Long term capital gain

Conclusion: Bond Mutual fund taxes are applicable only on redemption while on bank FD’s taxes are applicable on accrued interest; Bank FD taxes would be 10 times higher than that of bond mutual fund. Bond Mutual fund provides higher return, offers better liquidity and most efficient in terms of taxes compared to Bank FD.

Bond/Debt Mutual Fund: An Overview

Bond/Debt mutual funds are funds that invest in instruments such as Treasury bill & Treasury bond (issued by Government), Certificate of Deposit (issued by Banks), and Commercial Paper & Bonds (issued by corporate).

Categories of Debt Mutual fund

Category	Suitable for
Liquid fund Money Market funds Ultra Short term fund	Invest primarily in short term securities like certificate of deposit, Commercial paper, Treasury bill. Weighted average maturity of the fund would be less than 1 year. Often used as alternative to a savings bank account and can be used to park one’s surplus cash.
Short term Fund Medium term fund	Invest primarily in corporate bonds with tenor (maturity) of 1-5 years. Often used to generate return better than an comparable Bank FD and suitable for investors with investment Horizon of 1-5 year period
Long term Fund Income fund	Invest primarily in corporate bonds with tenor (maturity) greater than 5 years. Often used to generate return better than an comparable Bank FD and suitable for investors with longer investment horizon
Gilt funds	Invest primarily in Government securities; Gilt funds can be again classified as short term gilt fund (tenor less than 5 Years) and long term gilt fund (tenor greater than 5 year). Gilt fund have minimal credit risk but would be exposed to interest risk

Bank FD vs Bond/Debt Mutual Fund

Particulars	Bank Fixed Deposit	Bond/Debt Mutual Fund
Return	Fixed	Variable
Potential Return (>1 Year)	7-8%	9-10%
Maturity Period	Fixed period	·         Open ended schemes allows to redeem anytime ·         Closed ended schemes have fixed maturity
Pre closure	Pre closure penalty of 0.5-2%	·         Exit load might be applicable if exited within 1 year and can range from 0.5-1% for Medium/long term bonds. ·         No load when held for more than 1 year for medium/long term bonds ·         No load on liquid/ultra  short term bonds regardless of holding period
Partial withdrawal	Not allowed	allowed
Taxable	Yes	Yes
Taxable Impact	High	Low
Tax efficiency	Low	High

Conclusion: Bond/Debt Mutual Fund provides better return than equivalent bank FD with marginally higher risk; Bond/Debt Mutual fund provides lot of flexibility when it comes to liquidity and more tax efficient compared to a bank FD. So would advise to seriously consider Debt Mutual fund as an alternative to Bank FD.

For any investment related queries feel free to get in touch on 0965-65708812