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Thursday, June 13, 2013

Helping Clients Channelize Savings into Debt Funds vis.a.vis Fixed Deposits

In India most investors go to any extent to save income tax and run around to make last minute investments. Last minute tax planning is an age old practice that forces tax payers to make hasty and often wrong decisions. Typically, some individuals invest more than the required amount to save taxes. They also end up parking money in wrong products in the process, which may have an adverse impact on their cash flows and return prospects.
It is not surprising that the insurance industry do most of its business during the tax- saving season between January and March every year. Often investors tend to buy products or make investments without doing the due diligence on their total tax structure. Investors happily write out cheques to buy low-yield traditional insurance policies or take additional medical cover as long as it saves their income tax. But this enthusiasm to avoid the taxman is missing when they invest in debt instruments.
Your tax-saving investments should depend on your financial needs and goals. These should be distributed among assets classes to reap the dual advantage of lowering tax burden as well as building your portfolio. Equities are known to offer high return over the long term. However, it does not mean you should ignore debt investments.

The safety factor of debt funds

Debt funds are a direct alternative and competitor for bank fixed deposits. The primary areas of difference are safety and taxation (and thus returns), with mutual funds holding the advantage in tax-adjusted returns and fixed deposits in safety.
In theory, banks are safer but, there is no practical difference between the safety level of banks and debt funds as far as defaults of underlying investments go. As with all mutual funds, there are no guarantees in debt funds. Returns in debt funds are market-linked and the investor is fully exposed to defaults or any other credit problems in the entities whose bonds are being invested in.
However, in practice, the fund industry is closely regulated and monitored by the regulator, Securities and Exchange Board of India (SEBI). Regulations put in place by SEBI keep tight reins on the risk profile of investments, on the concentration of risk that individual funds are facing, on how the investments are valued and on how closely the maturity profile hews to the fund's declared goals.
In the past, these measures have proved to be highly effective and except for some small problems during the 2008 global financial crisis, debt fund investors have not had any nasty surprises. Practically speaking, you would be entirely justified in expecting not to face any defaults in your debt fund investments.
Fixed deposits, recurring deposits and small savings schemes get a big chunk of the household savings pie, while tax-efficient debt funds make do with small fragment. More than Rs 4,90,000 crore of household savings are in bank deposits, while debt fund investments by individuals add up to about Rs 18,300 crore. This minuscule allocation to debt funds is despite the huge tax advantage and other benefits that these schemes offer.

The effect of tax differential

Returns from bank fixed deposits are interest income and as such have to be added to your normal income. Since many investors are in the top (30 per cent) tax bracket, this effectively reduces return by an equal percentage.
With debt funds, the returns are classified as capital gains for investments of over 12-months for and are thus taxed at 10 per cent or 20 per cent with indexation which adjusts for inflation during the holding period. If you take into account indexation benefits, then the difference between FD returns and debt fund returns are quite large. And if you can time the investment to get double indexation benefits for say a 370 day deposit, then it’s quite a bonanza. Below is an illustration of effective returns from both the avenues;
Particulars
Income Funds
Bank Fixed Deposit
Investment Amount (Rs)
1,00,000
1,00,000
Rate of Return/Interest Rate (%) (p.a.)
10%
10%
Tenure (Days)
366
366
Gross Value after 1 year (Rs.)
1,10,000
1,10,000
Gain on Investments
10,000
10,000
Capital Gain Tax (@11.33%)
1,133
-
Tax on Interest Income (@30.9%)
-
3,090
Net Value after tax (Rs)
1,08,867
1,06,910
Effective Rate of Return (%)
8.87%
6.91%

Postponing the tax liability

The lower tax rate on capital gains, for instance, is just one of the benefits of these schemes. A major draw is that one can indefinitely postpone tax liability by investing in debt funds. The interest income is taxable on an annual basis, irrespective of the time that investor actually get it. Investor need to pay tax on the interest accruing on a cumulative fixed deposit or a recurring deposit even though the instrument has to mature in 5-10 years.
On the other hand, investments in debt funds will not have a tax implication till it is withdrawn. This also makes these funds the best way to invest.

Taking Advantage of Clubbing of Income

When the money is invested in minor child's name, the income from the investment is treated as that of the parent who earns more. This clubbing of income is meant to prevent tax leakage, but investments in mutual funds can circumvent this provision. If the funds are redeemed after the child turns 18, the capital gains will be treated as the child’s income, and not parents.

Setting off Losses

There are other ways to earn tax-free income from debt funds. You can set off losses from other assets against the gains from these schemes. Tax rules allow carrying forward of capital losses for up to eight financial years. For instance, if you had booked short-term losses on stocks and equity funds when the markets slumped in December 2008, you can adjust them against the gains from your debt fund investments till 2015-16.
What if you need the money before one year? Any short-term capital gain is taxed as income, but you can get past this with the dividend advantage. Though they are tax-free, dividends of debt schemes reach the investor after the deduction of dividend distribution tax. This is 13.8% for debt funds and 27.4% for liquid funds. Even so, this is lower than the 30% tax an investor in the highest income bracket will pay on withdrawals before one year of investment.

Liquidity Advantage

Apart from these tax advantages, debt funds also offer a higher liquidity and more flexibility than a bank deposit. When you invest in a fixed deposit, you lock up money for a certain period. Sure, the deposit can be broken any time, but you end up sacrificing returns. There is usually a small penalty to be paid when you withdraw prematurely.
Debt funds also levy an exit load, but the quantum of load as well as the minimum period of investment varies across funds and categories. Most liquid funds and ultra short‐term funds, for instance, do not have exit loads, but medium‐term income funds may charge 0.25‐0.5% if you leave within six months or a year of investment. In some cases, this may even be as high as 1‐2%. So it pays to check the exit load and minimum investment period before you buy a fund.

Flexibility

The other advantage is the flexibility and ease of investment. The Public Provident Fund has annual limits—the minimum investment is Rs.500 and the maximum Rs 1 lakh. The tenure is fixed at 15 years but can be extended in tranches of five years. The Senior Citizens Savings Scheme has a maximum limit of Rs 15 lakh per individual and is for five years. No such limits apply to mutual funds. You can invest as much as your pocket allows. "Unlike small savings schemes, there is no limit to how much an individual can invest in debt funds,"
Besides the convenience of SIP investing, facilities such as systematic transfer plans (STPs) and systematic withdrawal plans (SWPs) make things easier for the debt fund investor.
Unaware of debt funds as a fixed income product, many investors opt for Banks fixed deposits or small savings schemes. But, Debt funds if used properly and selected wisely can be a good alternative to other fixed income investments.

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