Enjoy Multiple Tax Advantages in Mutual Funds over Bank Fixed Deposit

Is savings on your mind? Well, in that instance, fixed deposit automatically comes to your mind while you plan for your investment. It’s readily not always good as a conservative investor to opt for fixed deposits considering them to be risk-free and labelling them as “guaranteed returns”, especially at the times of falling interest rates which have whack around 40% from the annual income as compared to the return of a normal fixed deposit. Over the past years, you would have seen the falling rates regime in fixed deposit, it’s high time you prepare yourself to shift your focus from fixed deposits to mutual funds.

Mutual Funds Vs. Fixed deposits

Let’s quickly have a summarized overview of Mutual Funds Vs Fixed deposits:

CriteriaMutual FundsFixed Deposits
Rate of Returns No Guaranteed ReturnsFixed Returns
RiskMedium to High RiskLow Risk
Inflation-Adjusted ReturnsPotential for High-Inflation Adjusted Returns Comparatively Low Inflation-Adjusted Returns
Nature of LiquidityLiquidMedium to Low Liquidity
Cost of InvestmentManagement CostNo Cost
Premature WithdrawalPermissible with Exit LoadPermissible with Penalty
Status of TaxBeneficialBased on Tax Slab (subject to individual tax status and nature of investments)

Although the returns of mutual funds are not guaranteed, the chances are of making the most from it provided you have done your homework. Based on your financial goals, risk-taking appetite and timing to remain invested plays a dominant role in deciding the profitable returns for you. But understanding taxation is like the cherry on the cake.

For investments of less than three years, the tax treatment will remain similar to both mutual funds and fixed deposit. However, if you look for selling the entire mutual fund, the earnings will always be taxed on the same grounds as that of FD. Suppose, your investment goal is to realize the capital gains from your mutual fund so in that case, the tax paid on mutual funds will be less. Now let’s do some math in order to understand the tax treatment of mutual funds.

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Tax Implications of Investing in Mutual Funds

Let’s examine a case and understand the tax implications of investing in Mutual Funds:

As an investor, you have already deployed entire sum of ₹ 20 lakhs in a bank fixed deposit. Since bank Fixed Deposits provide you lesser interest rate starting from 6.50%-7.00% per annum for 1 year time period for which you are not readily convinced in fulfilling your upcoming financial goals. You have decided to shift entire₹ 20 lakhs in debt mutual funds of a particular mutual fund house for 3 years. At the time of your investment, the NAV stands out to be ₹ 200. Thus, you will obtain 10,000 units of the scheme.

Let’s further assume that your debt mutual fund gives you a return of 7% over the next year. Your NAV will grow from ₹ 200 to ₹ 214. Your investment value will give you ₹ 21.4 lakhs with an unrealized gain of ₹1,40,000.

Suppose you are in need of ₹ 3 lakhs for financing your emergency expenses. There is no requirement to redeem the entire investment. You can simply redeem ₹ 3 lakhs. But what to do when the time period of your mutual funds is of 3 years? No need to worry. You can still redeem if you want to liquidate some amount after 1 year. Let’s see how to redeem mutual fund units.

Redeeming Mutual Fund units

Number of units to be redeemed = ₹3 lakhs/ ₹214 =1402 units

Therefore, you need to redeem 1402 units from your debt mutual fund for getting your desired amount of ₹3 lakhs.

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How much Taxes do I need to pay on Redemption?

Wish to know how much taxes do you need to pay on redemption? Well, you need to understand that you qualify to pay taxes only on the number of units you wish to sell off( i.e. 1402 units from the above example).

As you have sold 1402 units within 3 years(after 1 year of holding your debt mutual fund), you need to remember that such gains will become entitled to short-term capital gains tax. You will have to pay such tax at your marginal income tax rate.

Short Term Capital Gains Tax(STCG) = No. of units sold * ( Sale price – Purchase price )

= 1402*(214-200)=₹19,628

Do note that the capital gains tax liability is only on the number of units you sell off. For the units you continue to hold further, there is no likelihood of further capital gains tax.

If you are in the highest tax earning range, your tax liability will only become ₹5,547.

Contrast with Fixed Deposit Returns

Instead of deploying your investment in mutual funds if you have had considered investing ₹ 20 lakhs in the fixed deposit which gives you 7.00% interest rate for 1 year. You would surely be entitled to come under taxation liability.

Let’s assume your fixed deposit earned the same rate of return of 7% p.a.

Your investment of ₹20 lakhs makes the value of your investment to grow upto ₹ 21.43 lakhs at the end of the first year.

Even though you have to liquidate only ₹ 3 lakhs, you have to pay tax on the entire interest which you have earned during the year.

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Since you have earned interest of ₹1,40,000, your tax liability will be ₹ 42000 (assuming you are in 30% tax bracket).

The tax liability on your fixed deposit will stand out to be ₹ 42000.

Do note that Tax Deducted at Source will further combat the balance in favour of debt mutual funds as against fixed deposits.

Now you must have understood the benefits you would obtain while investing in mutual funds where you can rescue yourself from paying heavy taxes while pulling out some amount to fulfil your emergency expenses requirement thereby continuing with your investment.

Disclaimer – Mutual Funds are subject to market risks. Please read the scheme related documents carefully before investing.