What are the comparisons and differences between FDs and debt mutual funds?

Budget 2023

Debt mutual funds were considered a tax-efficient investment option due to the favourable long-term capital gains (LTCG) tax treatment. Gains from debt funds held for more than three years were taxed at a concessional rate of 20% with the benefit of indexation, which allowed investors to adjust their cost basis for inflation. This made debt mutual funds more attractive compared to bank fixed deposits (FDs), where interest income was taxed at the individual’s applicable tax slab.

Changes introduced in Budget 2023

The Budget 2023 removed the LTCG tax benefits for debt mutual funds. This means that gains from these funds, irrespective of the holding period, are now taxed at the investor’s applicable tax slab, similar to short-term capital gains. The indexation benefit has also been withdrawn for these funds.

Impact of the changes

The removal of LTCG tax benefits has reduced the tax attractiveness of debt mutual funds compared to FDs. Investors in these funds will now face higher taxes on their gains, especially those in the higher tax brackets. This could lead to a shift of investments away from debt mutual funds towards FDs or other tax-saving instruments. The new tax regime applies to investments made in debt mutual funds on or after April 1, 2023. Investments made before this date will continue to be taxed under the old rules.

Differences between FDs and debt mutual funds

There are a multitude of differences between FDs and debt mutual funds. We have covered the key aspects below:

Risk: Fixed deposits are considered low-risk investments, as they offer a guaranteed return on investment (ROI) for a predetermined period. The investor’s principal remains secure, shielded from market fluctuations. In contrast, debt mutual funds possess a slightly higher risk profile due to their exposure to interest rate movements. However, the risk associated with debt funds is generally considered moderate compared to equity investments.

Working: Fixed deposits involve locking in an amount of money for a fixed tenure, ranging from a few months to several years. The investor earns a predetermined interest rate on the deposited amount, paid out periodically or at maturity. In contrast, debt mutual funds pool money from multiple investors to invest in a portfolio of debt instruments such as bonds, treasury bills, and commercial paper. The fund manager actively manages the portfolio, aiming to generate returns that surpass the benchmark index.

Returns: Fixed deposits typically offer lower returns compared to debt mutual funds. However, it is pertinent to note that recently the interest rates offered on fixed deposits have been rising, consequently many fixed deposits are now offering returns that are comparable and in many cases better than returns achieved typically by low-risk debt mutual funds. The interest rates offered by banks are often influenced by broader economic conditions and may fluctuate over time. Debt mutual funds, on the other hand, have the potential to generate higher returns due to their dynamic nature and exposure to various debt instruments. However, the returns from debt funds are not guaranteed and may vary depending on market conditions and the fund manager’s performance.

Taxation: The taxation of debt mutual funds and fixed deposits differs in some aspects. Interest earned on fixed deposits is taxed as per the investor’s income tax slab. As elaborated above the capital gains on debt mutual funds are also taxed as per the tax slab of the investor after the budget 2023. However, it is important to note that in the case of tax-saving fixed deposits, the investment in the tax-saving fixed deposits is tax-exempt under Section 80C of the Income Tax Act, up to a limit of ₹1.5 lakh per year. There is no such tax exemption available in the case of debt mutual funds. 

Frequency of returns: Fixed deposits provide a fixed interest rate, which is paid out periodically or at maturity. Debt mutual funds, on the other hand, are highly liquid and typically can be sold at any point in time, however, it is important to note that most investors hold their investment in debt mutual funds for a long period of time. 

Liquidity: Fixed deposits are less liquid than debt mutual funds. Early withdrawals from fixed deposits typically incur penalties, and the investor may not receive the full amount deposited. Debt mutual funds, on the other hand, offer relatively higher liquidity. Most debt mutual funds allow redemptions at any time, with the redemption proceeds typically being credited to the investor’s account within a few days.

The choice between debt mutual funds and fixed deposits depends on an individual’s risk tolerance, investment horizon, and financial goals. Fixed deposits offer the security of guaranteed returns and are suitable for investors seeking low-risk options. Debt mutual funds have the potential to generate higher returns but also carry slightly higher risk. Investors with a longer investment horizon and a moderate risk appetite may find debt mutual funds a more attractive option. 

In conclusion, a thorough understanding of the characteristics and nuances of both debt mutual funds and fixed deposits is essential for making informed investment decisions. Investors should carefully consider their risk tolerance, financial goals, and investment horizon before choosing between these two instruments. Consulting with a financial advisor can provide valuable guidance and help tailor an investment strategy aligned with individual needs and preferences.

Kuvera is a free direct mutual fund investing platform.

Note: This is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.

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Updated: 17 Nov 2023, 08:48 AM IST