- The outlook for debt markets remain positive
- Debt mutual funds score over mutual funds in terms of tax efficiency
- Debt funds also offer the advantage of liquidity
But what about the income tax factor? In case of bank deposits, the interest income is simply added to the investors' income and taxed according to their respective tax slabs.
Apart from falling interest rates, the tax factor is also one of the reasons why financial planners suggest systematic withdrawal plans (SWP) in debt mutual funds to be a better option for investors - particularly those in higher tax brackets - looking to earn a regular income from a lump sum.
Debt funds also offer the advantage of liquidity in case investors want to withdraw. The outlook for debt funds also remains positive. Manoj Nagpal, chief executive of Outlook Asia Capital, expects interest rates to fall further by another 100-150 basis points by 2018, which will further boost debt markets. Debt markets rally when interest rates go down.
"Globally debt markets have been in a structural down-move of interest rates due to subdued growth rates and lower inflation. This is a part of the reason for the lower interest rates in India too in addition to the fundamental of the Indian economy strengthening," he added.
What systematic withdrawal plan is
It is a facility which allows investors to withdraw money from a mutual fund scheme at regular intervals. Investors looking for income at fixed intervals typically opt for this option.
SWPs are usually available in two options. In the first option, a fixed amount as specified by the investor is withdrawn at regular intervals such as monthly, quarterly etc. In the other option, investors can withdraw the appreciated amount on monthly/quarterly basis.
Investments in debt funds are considered long term only if they are held for more than three years. Currently, the long-term capital gain on debt funds is taxed at the rate of 20 per cent. However, investors get the benefit of indexation on their original investment. This means that the original investment is adjusted for the price of inflation and taxed accordingly. Since the original cost of investment goes up after factoring in inflation, long term capital gains tax comes to negligible levels.
But if debt mutual fund investments are redeemed or sold before three years, the short-term gains are taxed according to the investor's tax slab. SWP in debt funds are tax efficient than fixed deposits even in the first three years of investment.
"SWPs are gaining popularity not only amongst small but high-networth investors as well - those who want a regular income stream. Debt-based SWPs allow safety of capital besides one can opt to receive a monthly inflow," says Preeti Khurana, chief editor of Cleartax portal.
For example, a person, who falls in the 20 per cent tax bracket, has Rs 20 lakh to invest and wants regular income. For simplicity, let us assume that both the fixed deposits and the debt mutual fund offer 10 per cent return.
On the Rs 2 lakh interest income generated for the first year from FD, the investor has to pay Rs 41,200 as tax.
In the case of the debt mutual fund, the investor will receive Rs 2 lakh from the systematic withdrawal plan as per his instructions to the fund house. Let us assume that the NAV of the fund has risen from Rs 10 to Rs 11 in a year.
So the fund house will redeem 18,182 units from his holdings to pay Rs 2 lakh. The cost of these 18,182 units for the investor was Rs 1,81,820 (18,182 X Rs 10). So the income tax would be levied only on the capital gains of Rs 18,000 (Rs 2 lakh - Rs 1.82 lakh). So the tax payout for the investor would be Rs 3,700 - as compared to Rs 41,200 in as of bank FD.