Debt mutual funds vs fixed deposits: Which is the one for you? Check tax implications, returns and more

Debt Mutual Funds (MFs) and Fixed Deposits (FDs) are both low-risk, conservative investment options for investors, offering them a secure way to build wealth.

While FDs feel safe and predictable with steady interest, debt MFs offer flexibility with market-linked growth. Both of these are taxed in the same manner now, making them equally attractive to investors. But are they equal? Let’s find out.

Fixed Deposit vs Debt Mutual Funds

First, the basics: In Fixed Deposits, or Term Deposits, you invest a lump sum amount for a fixed tenure ranging from a few days to up to 10 years, at a pre-determined interest rate. Upon maturity, the financial institution gives you the principal along with the accrued interest. These are secure investments, offering assured returns unaffected by market fluctuations.

Debt mutual funds are MFs that invest in fixed-income securities like bonds, treasury bills, government securities, debentures, commercial papers and certificates of deposit. These funds may also provide steady returns over time, usually higher than savings accounts or fixed deposits, with lower risk compared to equity-oriented funds. However, when compared to FDs, the risk in debt MFs is on the higher side.

Taxation

Until March 2023, debt MFs had an added tax advantage: Funds held for less than three years, treated as short-term capital gains (STCG), were taxed as per the individual’s income tax slab rate with no indexation. Further, if held over three years, they were treated as long-term capital gains (LTCG) and were taxed at 20% with indexation benefit. Indexation adjusted for inflation, which reduced taxable gains and served as a major tax advantage.

Now, since April 2023, debt MFs are also taxed as per your slab, both short-term and long-term. Fixed deposits are also taxed as per the income tax slab. The difference lies in when the tax is paid.

FDs are taxed annually, even if you don’t withdraw them. This reduces the base every year, impacting the compounding. So, even if your FD reinvests interests, tax is still the first hurdle.

Debt funds, on the other hand, are taxed only when you sell. This helps the principal amount to grow, making compounding do its work with ease.

For example:

Let’s say you invest ₹7 lakh for 5 years, and both FDs and debt MFs offer an interest of 7% per year. Here is what it will look like:

This means that the higher your tax slab, the higher the difference. At the 30% slab, you will have ₹17,000 more with a debt fund, just because of when the tax is paid.

Furthermore, timing plays a big role. If you’re in the 30% tax bracket, but retiring in 6 years:

• If you invest in an FD, you will pay 30% tax on interest every year.
• If you buy a debt MF, you will pay no tax until you redeem at retirement, where you could be taxed at just 10% if you fall in a lower tax slab then.

By this, you can save over ₹1.2 lakh just in taxes without sacrificing on returns.

In case of FDs, you get a TDS Exemption, which is:

• For normal citizens, TDS on FDs will only be charged if your total interest earned in a financial year goes above ₹50,000.
• For senior citizens, the limit is ₹1,00,000. This means TDS won’t be deducted if the interest in a year remains below ₹1 lakh.

Note: TDS exemption means that tax won’t be deducted at source, but the interest earned will still be taxable.

Types of FDs and debt MFs

• Regular FD: Standard FD with flexible tenure and fixed returns.
• Tax Saving FD: 5-year lock-in with tax benefits under Section 80C.
• Senior citizen FD: Offers higher interest rates for individuals aged 60 and above.
• Flexi FD: Linked to a savings account with auto-transfer and withdrawal flexibility.
• NRI FD: For NRIs, NRE FDs are tax-free, and NRO FDs are taxable in India.

• Based on tenure, like short-term (under 3 years), medium-term (3-5 years) and long-term funds (over 5 years).
• Based on fund management, like floating rate funds (variable interest rates adjusted over time), dynamic bond funds (active interest rate movements) and fixed maturity plans (closed-ended funds with a fixed maturity date).
• Based on the type of issuers, like Gilt Funds (G-Secs), Treasury Funds (treasury bills, other short-term G-Secs), Corporate Bond Funds (Debt issued by companies) and Infrastructure Debt Funds (Long-term instruments issued by infrastructure companies).

Risk and returns

Returns from debt funds may be influenced by factors such as changes in interest rates, the credit quality of underlying debt instruments, and broader market volatility. The Net Asset Value (NAV) of debt funds may fluctuate, especially when there are significant shifts in market conditions. While debt funds are safer than equity-based instruments, they are riskier than FDs.

Typically, debt funds provide returns in the range of 7-8%. On the contrary, FDs are more stable and predictable, offering a fixed rate of return. FDs also offer similar returns, lying between 3% to 8%, varying with the tenure.

For individuals who prefer guaranteed returns, FDs may be a more suitable option. With interest risk fluctuations and possible misjudgments by the fund managers, debt funds are way more risky than FDs.

Liquidity

Debt MFs are highly liquid, as one can redeem them anytime. However, few funds charge exit loads for short-term redemptions. FDs offer low liquidity, as most FDs charge a penalty on early withdrawals, varying from 0.5% to 2%.

Both FDs and debt MFs have their benefits and limitations. To make a decision, an investor must consider their financial goals, risk tolerance, and income and tax slab, among other things. Before investing in any of these, investors need to understand the differences and make a well-informed decision.