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.

How long would an investment portfolio of Re 1 crore at retirement last

Mr X retires with an investment portfolio of Re 1 Crore (cr) and is concerned about how long would his investment portfolio last or take care of his financial needs?

Longevity of protection from his investment portfolio depends on three important factors

1. Inflation (Non Controllable factor) – Inflation is the rate at which general level of prices for goods & services is rising. India’s Average inflation since FY 2000 (over last 17 years) stands at 6.5%. Mr X does not have any control over inflation and hence for analysis purpose let’s assume 5% long term inflation.

2. Monthly Investment Cash flow requirement (Controllable factor) – How much monthly cash flow Mr X requires from his investment portfolio depends on various factors like his other sources of income, life style, financial commitments etc.

For ex: Assume Mr X requires monthly expense of Re 1 lac for comfortable living. He gets a monthly pension of Re 25,000. So his monthly cash flow requirement from the investment portfolio would be Re 75,000 (Re 1 lac- Re 25,000).

3. Investment portfolio return (Controllable factor) – Mr X asset allocation would determine his return. Mr X could decide to park his money in an Bank SB account (potential to generate 0-3% CAGR return); invest in Fixed deposit instruments like bank FD, corporate FD, Bond Mutual Fund (potential to generate 4-10% CAGR return); invest in Equity instruments like Direct Equities, Equity Mutual Fund (potential to generate 8-15% CAGR return) or invest in alternative assets classes like gold, silver, real estate, REIT. Investors should take into account the tax impact as it would reduce investors return.

Mr X wishes to withdraw monthly Re 75,000 to meet his expenses and he is aware that inflation would push up his monthly expenses. The chart below depicts how long would Mr X  investment portfolio of 1 cr would last under various return scenarios.

Mr X investment portfolio would last / take care of his financial needs for only 8 Years at 0% return (held as cash). However if Mr X had wisely deployed his investment and generates 12% return on portfolio (Equity) then his portfolio would last/take care of his financial needs for 21 Years. Thus a wisely invested portfolio would last longer.

Conclusion: wisely selected investment portfolio during working years can significantly ease financial burden on retirement. if you don’t make your money work for you during working years then you might end up retiring late or lower the quality of life on retirement.

From the above example an investment portfolio held in fixed instruments (at 6% return) would last/take care of Mr X financial needs for only 11 years; while same portfolio held in Equity securities (at 12% return) would last/take care for 21 Years. Thus from the example a well held investment portfolio frees Mr X for 10 years (21 years-11 years); make your money work for you and retire comfortably.