What are Debt Funds? Debt Fund vs Fixed Deposit?

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Debt funds have become very popular in the past few years and many people had started shifting funds from Fixed Deposit to Debt Funds as the tax levied was very levy low on Income from Debt Funds as compared to Tax on Income from Fixed Deposit.

However, with the recent changes in taxation of Debt Funds, the benefits of investing in Debt Funds have been reduced to a large extent.

What is a Debt Fund?

A Debt Fund is a professionally managed fund which invests in highly rated fixed income earning investments like Govt Bonds, RBI Bonds, Money Market Instruments, and Corporate Deposits etc. The pool of investment is collected from the public and this investment is in-turn invested by this professionally managed in highly rated fixed income earning investments with low risk.

Debt Funds are just like Mutual funds in the sense that a pool of funds is collected from the public and then invested by the professionally managed funds in other investments. The only difference between Debt Funds and Mutual Funds is that Debt Funds invest mainly in Fixed Income earning Investments and Mutual Funds invest mainly in Stock Markets.

As a result of this difference in the kind of investments these funds are put into, Debt Funds are much safer as compared to Mutual Funds as they have low or negligible risk.

Moreover, as these funds are professionally managed they also yield a better return as compared to Fixed Deposits. Although, these debt funds charge a small percentage as their expense, the returns generated after payment of expense in most of the cases is higher than those generated by Fixed Deposits.

Just like Mutual Funds, the Debt Funds are also valued at NAV’s which keep changing on a daily basis. Although the returns in case of Debt Funds are not assured, in most of the cases, the return is almost equivalent to Return on Fixed Deposits. The monthly, quarterly and annual returns generated by a few of the Debt Funds are given in this link.

Debt-Fund-1

Debt Funds vs Fixed Deposits: Which is better?

The above link clearly indicates that the returns generated by the most of the Debt Funds are almost equal to the returns generated by Fixed Deposits. However, these are pre-tax returns and when tax is levied on these returns; there is a considerable difference in the net effective post tax returns. This is because of the fact that both Fixed Deposits and Debt Funds are taxed differently.

Tax on Fixed Deposit is calculated as per the Slab Rate and the Tax on Debt Funds is calculated as per Income Tax Slab Rate in case of Short Term Capital Gains (i.e. less than 3 year) and in case of Long Term Capital Gains (i.e. more than 3 year) it is calculated at 20% in case no indexation is done and at 20% in case Indexation is calculated.

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In case the period of investment is less than 3 year, the taxation would remain the same i.e. as per the Slab Rates. However, in case the period of investment is more than 3 year, there would be difference in the manner of computation of tax.

This can be explained with the help of an example. Assuming both Debt Funds and Fixed Deposits give the same return i.e. 9% per annum, the tax would be calculated as follows

Particulars

Fixed Deposit

Debt Fund
Return

9% p.a.

9% p.a.
Tax Rate 10% Slab 20% Slab 30% Slab Flat 20% in all cases
Post Tax Return 8.1% p.a. 7.2% p.a. 6.3% p.a. 7.2% p.a.

The above table clearly indicates that even if the pre-tax return is same in case of both Fixed Deposit as well as Debt Funds, the post tax return in case of Debt Funds would be higher than the post tax return of Debt Funds for Individuals in the 30% Income Tax Bracket.

Other Benefits of Investing in Debt Funds over Fixed Deposits

In case of pre-mature withdrawal from the Fixed Deposits, 1% penalty is levied. In case of Debt Funds, 1% penalty is levied in case withdrawal is made before the specified period. This specified period is not big and is usually in 6-12 months

Moreover, Tax is paid on Interest earned on Fixed Deposit every year. Moreover, TDS is also liable to be deducted on Fixed Deposit. Whereas in case of Debt Funds, tax is levied at the time of sale of the Debt Fund. So in case a Debt Fund is sold after 6 years, tax would be levied only on sale i.e. after 6 years whereas in case amount is invested in Fixed Deposit, the tax would be liable to be paid every year.

Conclusion

In case of the period of holding is short term i.e. less than 3 year, both Debt Funds and Fixed Deposits are taxed equally and also levy the same penalty in case of pre mature withdrawal.

However, in case the period of holding is more than 3 years, for individuals falling in the 30% income tax bracket – the tax on Debt Funds is lower than Fixed Deposits and no penalty is levied in case of pre-mature withdrawal as well.

Therefore, before investing in any of these forms of investment, it is important for the investor to decide that if he wants to invest in Debt Funds or Fixed Deposits. If he intends to invest for more than 3 year and he is in the 30% Income Tax Bracket– Debt Funds are advisable and if he intends to invest for less than 3 year – Fixed Deposits are advisable.

A Personal Finance enthusiast, Karan is the founder of charteredclub.com and loves to discuss about Money related matters.