Why debt funds are better than FDs

There is something to cheer and something to worry about the Union Budget. Taxable limit has been increased from Rs 1 lakh to Rs 1.1 lakh, Rs 1.35 lakh to Rs 1.45 lakh in case of women assessee and from Rs 1.85 lakh to Rs 1.95 lakh in case of senior citizens. There is no change in tax rates, only education cess has increased by 1 per cent.

But there is one major change, and that is in dividend distribution tax. DDT on equities has increased from 12.5 per cent to 15 per cent, and in case of debt funds, there is a drastic increase, DDT has increased from 12.5 per cent to 25 per cent. There is chaos among investors of debt funds.

If we consider surcharge and education cess, DDT works out to 28.325 per cent. Another major provision is the TDS limit on bank interest has been raised from Rs 5,000 to Rs 10,000. But still debt fund is the better alternative to high networth individuals.

Let us see how debt funds are more tax effective than the fixed deposit. First of all debt should form at least a part in your asset allocation strategy. No one is advised to invest full 100 per cent in equities. So naturally investors have to take some exposure to debt instrument.

Now the investor has got two choices either to go for the debt fund or to opt for the bank or company fixed deposit. As the for those who are in the lower tax bracket for them bank fixed deposit is a good alternative. But for high networth individual debt fund is more tax effective.

Investors should note here that DDT is to be paid by the fund house and not by the individual investor. Previously debt fund had declared handsome dividends

But as it is incurred by the fund house, it is quite possible that the fund house will be able to disperse less amount because of the increased burden. Any dividend received by the investor is tax-free in the hands of the investors.

Now DDT is increased to 25 per cent, over and above this 25 per cent there is a surcharge of 10 per cent and education cess of 3 per cent, so effectively it comes out to be 28.325 per cent.

In case of the taxpayer in the highest bracket, the tax rate is 30 per cent plus 10 per cent surcharge and 3 per cent education cess on this amount, so tax rate works out to be 33.99 per cent.

So if we consider the difference between these two tax rates, it comes out to be 5.665 per cent. So by investing in debt fund, still there is a saving of 5.665 per cent.

Now for the investors in debt fund, there are two options, first one is the dividend and the other one is growth. If investor wants regular income, then he has to choose the dividend option.

Now on dividend DDT is to be paid. If the investor holds the fund for more than three years, he has to incur long term capital gains. In this case he can very well get the benefit of cost of inflation index (CII), and, further, the LTCG is payable at concessional rate of 20 per cent.

Let us consider an example, an investor has invested Rs 10 lakh in debt fund and opted for dividend payout. Suppose the fund has surplus of Rs 90,000 to be distributed to this particular investor.

But the fund house has to pay DDT of 28.325 per cent, which comes out to be Rs 25,493, so it is left with Rs 64,507 to pay as dividend to the investor.

So effectively investor yields 6.45 per cent on his investment. Suppose the investor had invested in bank fixed deposit, then the interest of Rs 90,000 is taxable in the hands of the investor as the income from the other sources.

 

DDT
Scheme name	DIVIDEND IN Rs.
Templeton (i) st income (qd)	13.15
Tata liquid fund-ship (md)	5.97
Sahara liquid variable pricing m	4.94
Reliance liquid –tp-ip (md)	2.19
Dsp ml liquid fund-ip-wd	1.26

As per new tax rates, tax on this interest comes out to be Rs 30,591, and the investor is left with only Rs 59,409, the effective yield in this case is 5.95 per cent. So still the investor is better off with 0.50 per cent more yield, that is, Rs 5,098. So even dividend option works out to be better than the fixed deposit.

Now we will consider an example of an investor who has invested Rs 10 lakh in debt fund in March 2002 at NAV Rs 10, and the NAV has appreciated to Rs 13 in April 2005.

The investor sold the investment in April 2005 and has gained Rs 3 lakh. But as the investor has held the fund for more then 36 months, it will be counted as long term capital gain, and he will get the benefit of indexation.

As the investor has invested in March 2002 and disposing of the investment in April 2005, he will get indexation benefit for 4 years. For the cost of acquisition we have to take index of 2001-02, which was 426, and in 2005-06, which was 497.

So his indexed cost of acquisition is cost of acquisition.

CII in the year of sale/CII in the year of purchase= Rs 10,00,000*497/426= Rs 11,66,667. So the capital gain comes out to Rs 1,33,333. The investor has to pay Rs 30,213 tax on this investment.

Now suppose if the investor had invested in fixed deposit at 8.5 per cent for the same period of 37 months. Then at the end of the 37 months, he will receive Rs 12,98,435. So the interest component of Rs 2,98,435 is taxable under the head income from other sources at the normal tax rate.

So the tax on this investment works out to be Rs.1,01,438. So the difference between taxes paid under the two situations is Rs 71,225. So in such a scenario, the debt fund investor is far better off than the fixed deposit investor.

Verdict: So though the DDT has increased to a large extent, investors should not bother about this change and can well go ahead with debt funds.