Falling Interest Rates, Higher Taxes...Are Bank FDs Worth It?

Banks fixed deposits are among the most popular instruments among Indians as they provide fixed-guaranteed return. Though safety of capital and guaranteed returns are the two virtues of bank fixed deposits, tax inefficiency takes the charm away from them. The interest earned on fixed deposits is fully taxable.

Currently, banks are offering an interest of 7 per cent on five-to-ten-year deposits. But with inflation hovering around six per cent, the post-inflation and post-tax return for a person in the highest tax bracket is almost negligible.

So for those looking for better tax-efficient alternatives, here are some of the options:

1) Debt mutual funds: These are mutual funds which invest in debt papers like corporate debt, and government securities of various maturities and have the potential to deliver better returns than fixed deposits. "Banks deposits go through cycles and won't be able to offer higher returns in a falling interest rate scenario but as debt funds invest in a variety of instruments, they can deliver better returns, said Vidya Bala, head of mutual fund research at FundsIndia.

In a falling interest rate scenario, while new fixed deposits will give lower returns, debt funds actually tend to benefit and can even give double-digit returns, she added.

Apart from this, debt funds are more tax efficient than bank fixed deposits. Returns from debt funds after three years are subjected to 20 per cent tax but they can be adjusted against cost of inflation, thus reducing the tax impact to negligible levels. Short-term gains on debt funds are added to the income of the investor and taxed as per the slab, just like fixed deposits.

2) Arbitrage funds: An arbitrage fund is a type of equity mutual fund that tries to take advantage of the price differential (of the same asset) between the cash and derivatives (future) markets. The entire equity portfolio is hedged as they buy the same stock in cash and derivative markets. Their returns are comparable to that of debt funds. The biggest advantage they have is that they enjoy the same tax status as that of equity funds. Therefore, capital gains after one year as well as dividend received from arbitrage funds are tax free.

"The main attraction of arbitrage funds is taxation of returns but investors should keep in mind that unlike bank fixed deposits, returns from arbitrage funds is not fixed," says Jitendra Solanki, a certified financial planner.

However, it is the complexity of the product that keeps many investors away from these funds, say experts.

3) Tax-free bonds: As the name suggests, the interest income earned from these bonds are tax free. As they are issued by government entities, they are as safe as fixed deposits. This financial year, however, there would not be fresh issues of tax-free bonds. Since tax-free bonds are traded on exchanges, investors looking to put money in these bonds can buy them from secondary markets.

However, investors investing tax-free bonds should keep the liquidity factor in mind. As these bonds are thinly traded on exchanges, they may not be able to sell them whenever they would want to. Also, investors should consider the price at which the bonds are available in the secondary market.

"Investor should understand if they are buying at a right price and if the yields will continue to be attractive for them. The yield of a bond is the coupon rate divided by the market price of the bond," Ms Bala said.