Last week major banks including State Bank of India, Punjab National Bank, United Bank of India and Karnataka Bank Ltd increased their deposit rates across select maturity periods. The rise in deposit rates have been in the range of 25-125 basis points (bps). Analysts say the rates are increased to bridge the asset-liability mismatch or to meet the higher loan demand.
For short-term depositors in the lower tax bracket, this may be good news, but for investors in the higher tax bracket this may not serve the required purpose. In the long term, returns from bank deposits, such as fixed deposits (FDs) and recurring deposits (RDs), get eaten into by tax and inflation rates and these are fairly large bites.
The tax bite: FD and RD rates as of now are in the range of 8.75-9.25%. But a chunk of it would get eaten into by the tax component.
Let's take State Bank of India's current interest rate of 8.75% on FD for a tenor of one year to less than two years for up to R15 lakh. For an individual falling in the 30.9% tax bracket, a 8.75% annual return would get reduced to a net return of 6.05%. If you are in the 20.6% tax bracket, then your net return will be 6.95%. For those who are in the 10.3% tax bracket, the net return will be 7.85%.
The inflation bite: The next step would be to adjust the post-tax returns with inflation, which reduces the value of investments.
For instance, if you earn a net return of 7% and if the inflation is at 7%, your investment value would be equal to the value of your money when you began the investment. The average rate of inflation for the last five financial years has been at around 7.5%.
Consider the example mentioned earlier in the story: a post-tax return of 6.05% for individuals in the highest tax bracket will translate to a negative figure of -1.45%, assuming five-year inflation at around 7.5%. However, if you are in the lowest tax bracket of 10%, you will get a positive return of an insignificant 0.35%.
You can invest a maximum of R1 lakh in a financial year and you get a tax deduction of up to R1 lakh under section 80C of the Income-Tax Act. However, this comes with a five-year lock-in period.
The tax bite: Let's assume your taxable income is R5 lakh and you put R1 lakh in a tax-saver FD. Your taxable income for that year reduced to R4 lakh. The interest that you earn will be liable to tax. Hence, five years down the line the amount you get will be deducted for tax every year based on your tax slab. So if the bank gives you 9% interest on your five-year tax-saver FD, the post-tax return will be 6.22% for the highest tax bracket along with a savings of R3,090 on that R1 lakh deduction.
The inflation bite: Deduct inflation rates of 7.5% over the tenor and the return for the highest tax bracket reduces to -1.28%.
What should you do?
As interest is taxed at the highest marginal rate for banking products it would make sense if you look for investment instrument with lower tax and better returns.
"Instead of looking to invest in FDs or RDs, it would be better for you to consider debt mutual funds as they are taxed at a benign rate of 10% without indexation and 20% with indexation (when you sell units)," said Suresh Sadagopan, a Mumbai-based financial planner. "Mutual funds have better liquidity arrangements than bank deposits. You can even consider tax-free bonds that are currently available in the market."
If you go for a divided option on debt MFs, dividend distribution tax (DDT) will be applicable when you earn dividends. In the budget, DDT on debt MF was raised to 25%. The category average returns of short-term debt funds in Mint50, Mint's 50 curated mutual funds, is 9.51% over a two-year period.
"Gold exchange-traded funds and gold funds are also good options as gold has a proven track record of beating inflation," said Arvind Rao, chief planner, Dreamz Infinite Financial Planner.
"The only asset class that can beat inflation is equity. But this works only in the long term - at least five years," Surya Bhatia, certified financial planner and principal consultant, Asset Managers.
As there is a deduction of up to Rs. 10,000 from interest income from savings account, you would get a better return than FDs in which the interest doesn't exceed Rs. 10,000. For instance, if you leave R1 lakh in your savings account that earns 7% interest (the highest that some banks are paying currently), you will get R7,250 as interest considering daily compounding.
"Savings account will end up giving you better returns than FD. However, this holds true till you don't exceed Rs. 10,000 as interest income from savings account," said Rao.
So it may be reasonable to check your savings account rate if you are considering opening an FD with a small amount.