What are the differences in taxation between a fixed deposit and a liquid mutual fund?

 

Introduction

 

    Fixed deposits (FDs) and liquid mutual funds are two of the most popular investment options in India, especially for conservative investors seeking safety and liquidity. While both instruments serve the purpose of parking funds for short to medium-term financial goals, they differ significantly in terms of returns, liquidity, and especially taxation. Understanding the tax implications of each can greatly influence an investor’s choice, as taxation directly affects the net returns. This detailed discussion explores the taxation of fixed deposits and liquid mutual funds, highlighting the differences and their impact on an investor’s overall financial planning.

 

Taxation of fixed deposits

 

Interest income taxability:

 

     The primary income from a fixed deposit is the interest earned, which is fully taxable under the head "Income from Other Sources." The interest income is added to the investor’s total income and taxed according to their income tax slab. For instance, if an investor is in the 30% tax bracket, the interest earned on the FD will be taxed at 30% (plus applicable cess).

    This means that for an investor in the highest tax bracket, the post-tax returns on a fixed deposit can be significantly lower than the nominal interest rate offered by the bank.

 

Tax deducted at source (TDS):

 

     Banks are required to deduct TDS on the interest earned on fixed deposits if the total interest income exceeds ₹40,000 in a financial year (₹50,000 for senior citizens). The TDS rate is 10% if the investor has provided their PAN to the bank; otherwise, the rate is 20%.

    It is important to note that TDS is not the final tax liability. If the investor falls into a higher tax slab, they need to pay additional tax when filing their income tax return. Conversely, if the investor’s total tax liability is lower than the TDS deducted, they can claim a refund.

 

Taxability on accrual basis:

 

     Fixed deposits, particularly cumulative ones, accrue interest annually, even though the interest is paid out only at maturity. For tax purposes, the interest is considered as income on an accrual basis, meaning the investor is required to pay taxes on the interest every year, even if it is not received in cash.

   This accrual-based taxation can be a disadvantage for investors as it increases the complexity of tax calculations and might lead to a mismatch between cash flows and tax liabilities.

 

Impact on post-tax returns:

 

     The high tax burden on FD interest can significantly reduce the effective returns, particularly for those in higher tax brackets. For instance, an FD offering 6% interest will yield only 4.2% post-tax for an investor in the 30% tax bracket. This can make FDs less attractive, especially when inflation is considered.

 

Taxation of liquid mutual funds

 

Capital gains taxation:

 

     Liquid mutual funds do not generate interest but rather yield returns through capital appreciation. The taxation of these gains depends on the holding period of the investment. If the units of the liquid mutual fund are held for up to three years, the resulting gains are considered short-term capital gains (STCG) and are taxed at the investor’s applicable income tax slab rate.

   If the units are held for more than three years, the gains are classified as long-term capital gains (LTCG) and are taxed at a concessional rate of 20% with the benefit of indexation. Indexation adjusts the purchase price of the units for inflation, thereby reducing the taxable capital gain and the overall tax liability.

 

Short-term capital gains (STCG):

 

     STCG from liquid mutual funds is added to the investor’s total income and taxed at the applicable income tax slab rate. This is similar to the taxation of FD interest, but the structure of mutual fund returns often includes both capital gains and dividends, providing some tax diversification.

    The taxation of STCG at slab rates may reduce the attractiveness of liquid mutual funds for short-term investors, particularly those in higher tax brackets. However, the lack of TDS and the potential for higher returns compared to FDs might offset this disadvantage.

Long-term capital gains (LTCG):

 

     For investors who hold liquid mutual funds for more than three years, the tax treatment becomes much more favorable due to the indexation benefit. Indexation increases the purchase price of the units by factoring in inflation, thus reducing the capital gains and consequently, the tax payable.

    The effective tax rate after indexation can be significantly lower than the nominal 20%, making long-term investments in liquid mutual funds more tax-efficient compared to FDs.

 

Dividend Distribution Tax (DDT) and Post-2020 Taxation:

 

     Prior to the Finance Act 2020, dividends distributed by mutual funds were subject to Dividend Distribution Tax (DDT) at the rate of 29.12% (25% tax + 12% surcharge + 4% cess). This tax was paid by the mutual fund house before distributing the dividends to investors.

    However, after the abolition of DDT in 2020, dividends from mutual funds are now taxed in the hands of the investor at their applicable income tax slab rate. This change has made dividends less attractive for investors in higher tax brackets, as they are now taxed at the marginal rate rather than a flat rate.

 

Tax efficiency and post-tax returns:

 

    Liquid mutual funds offer greater tax efficiency compared to FDs, especially for long-term investments. The benefit of LTCG taxation with indexation significantly enhances post-tax returns, making liquid mutual funds a more attractive option for investors with a longer investment horizon.

    Furthermore, the flexibility to choose between growth and dividend options allows investors to manage their tax liabilities more effectively, tailoring their investment strategy to their tax situation.

 

Comparative analysis

 

Impact of tax slabs:

 

     Both FDs and liquid mutual funds are impacted by the investor’s tax slab. However, the tax treatment of FDs is generally less favorable, particularly for those in higher tax brackets, as the interest is taxed annually at slab rates. Liquid mutual funds, on the other hand, offer the potential for lower effective tax rates due to LTCG taxation with indexation, making them more tax-efficient for long-term investors.

Taxation frequency and cash flow considerations:

 

      Fixed deposits require investors to pay taxes annually on the interest accrued, even if the interest is not received in cash (in the case of cumulative FDs). This can create a cash flow mismatch, where investors have to pay taxes without receiving the corresponding income.

    In contrast, liquid mutual funds are taxed only upon redemption, allowing investors to defer taxes and benefit from compounding over time. This tax deferral can improve cash flow management and enhance overall returns.

 

Effect of Inflation and Real Returns:

 

The indexation benefit available for LTCG on liquid mutual funds accounts for inflation, effectively reducing the tax burden and preserving real returns. Fixed deposits, however, do not offer any such inflation adjustment, which can erode the real value of returns, especially in a high-inflation environment.

This makes liquid mutual funds a better option for investors looking to preserve or grow their wealth over the long term, as they provide a more tax-efficient way to combat inflation.

TDS Mechanism vs. Self-Assessment:

 

The TDS mechanism on fixed deposits can sometimes result in excess tax payments, especially for investors who are not in the highest tax brackets. This can lead to the need for refunds, complicating tax filing. Liquid mutual funds do not involve TDS, allowing investors to self-assess and pay taxes, providing better control over their tax liabilities.

Additionally, the absence of TDS in liquid mutual funds can enhance liquidity, as investors are not subject to immediate tax deductions on their returns, unlike in fixed deposits.

 

Conclusion

 

     In conclusion, while both fixed deposits and liquid mutual funds have their respective advantages and disadvantages, the key differentiator often comes down to their tax implications. Fixed deposits are simple, secure, and provide predictable returns, but their tax treatment can significantly reduce their attractiveness, particularly for high-income individuals. Liquid mutual funds, although slightly more complex, offer greater flexibility and tax efficiency, especially for long-term investments. The ability to benefit from LTCG taxation with indexation makes liquid mutual funds a compelling option for those looking to maximize their post-tax returns. Therefore, investors should carefully consider their tax situation, investment horizon, and financial goals when choosing between these two investment options.