With interest rates on bank fixed deposits, or FDs, touching nine to 9.5 per cent, are you wondering whether you should take the safe route and park your money in bank FDs, or invest in income funds?
Income funds are debt funds offered by mutual funds that seek current income rather than growth of capital. They invest in stocks and bonds that pay high dividends and interest. In the current scenario, most risk-averse investors would opt for FDs, as the lure of near doubledigit annual returns with almost no risk is too hard to resist, especially when the average return from the top 50 income funds in the past one year has been just eight per cent.
If you too have based your investment decision on the above premise, you may have erred not on one, but on two counts. First, you are comparing present FD rates with the past one year's performance of debt funds. Ideally, you should compare debt fund returns with FD rates a year ago. Second, the returns compared above are pre-tax, which may give you a wrong picture. "Ideally, debt fund returns should be compared to FD rates prevailing at the start of the period of comparison," says Srikanth Meenakshi, Director of Wealth India Financial Services. For example, if you are assessing the past one year's performance of a debt fund, say from July 2010 to June 2011, you should compare it to FD rates prevailing around July 2010. The FD rates at that time were 7 to 7.5 per cent, while the average one-year pre-tax return from income funds, as on July 4, 2011, was of 5.65 per cent.
Debt funds investment better than FDs
If you had invested in a one-year FD, your pre-tax return would have been 7 to 7.5 per cent - not the 9 to 9.5 per cent offered now. The top 50 income funds also gave a return of 7.5 per cent and above between July 5, 2010 and July 4, 2011. Fixed maturity plans, or FMPs, which are close-ended debt funds, gave an average return of 5.5 per cent in the same period.
FMPs are touted as good alternatives to FDs because they are more tax effi cient and carry a lower risk. If we compare the average returns of debt funds with those of FDs, the former have seen double-digit appreciation in their net asset value on an annualised basis, giving higher pretax return than FDs. Among income funds, Escorts Income Fund-Growth gave a return of 17 per cent, Religare Credit Opportunities 13.5 per cent and Tata FIPF C3-Regular,12 per cent. Among FMPs, ICICI Prudential SMART-Series H offered a return of 16 per cent in the same period.Tax implications
In a debt fund, the long-term capital gains tax (earnings from a fund held for one year and above) without indexation is 10 per cent, while it is 20 per cent with indexation. Shortterm capital gains tax is deducted according to your income tax slab. In indexation, the cost of investment is raised to account for infl ation for the period the investment is held. This is done by using a cost infl ation index number released by the central tax authorities every year. Dividend income from debt funds other than liquid funds is taxed at 12.5 per cent.
However, the interest earned on FDs is added to the total income of a person and then taxed according to his tax slab. Also, if the total interest earned on all your FDs is higher than Rs 10,000 in a fi nancial year, the bank will deduct tax at source.
The indexation benefi t table clearly shows that despite FD rates being higher than those for debt funds, post-tax gains are higher for the latter. "Considering that the overall impact on real return due to the indexation benefi t is signifi cant, a debt fund is defi nitely a better alternative to fi xed deposits in the long term," says Yadnesh Chavan, Fund Manager, Fixed Income, Mirae Asset Global Investments Private. Investors who pay 20 to 30 per cent tax on their earnings stand to gain more from tax-efficient debt funds.
Courtesy: Money Today