Invest in FMPs or FDs? Here's help

Fixed maturity plans are income schemes of mutual funds which if held till maturity practically guarantee protection of your capital - and yet offer higher returns and superior tax advantages than bank do FDs.

The secret of their higher returns lies in the fact that FMPs invest their corpus in corporate bonds, government securities, and money market instruments, etc., which enable them to earn higher returns than bank FD rates for similar periods.

Capital protection advantage

Typically, income funds are prone to "interest rate risk". Interest rates and prices of fixed income instruments, including income funds, share an inverse relationship. In simple words, when interest rates in the economy rise, the NAV of an income fund falls, and vice versa. This, in turn, leads to a possible capital "loss" if you exit from an income fund in times of rising interest rates.

FMPs effectively eliminate this interest rate risk by investing in instruments whose maturity coincides with the end of the FMP. So a 90-day FMP will invest in instruments maturing after 90 days, and so on. Thus, the fund manager of an FMP knows what the returns the scheme is going to yield. Holding the underlying instruments till their maturity effectively eliminates interest rate risk, as the value of the instruments at their redemption is known upfront.

However, though the return from an FMP is known in advance, these are not to be confused with the erstwhile assured return schemes, which SEBI has since banned.

The tax advantage

An FMP offers the advantage of lower tax in comparison to a bank FD.

The dividend from any scheme of any mutual fund is tax-free in the hands of the investor. However, FMP being a debt-based scheme, the mutual fund has to pay the dividend distribution tax @14.165 per cent. While bank interest does not incur this dividend distribution tax but the interest is fully taxable in the investor's hands.

Thus, dividend received by an individual from an FMP is effectively taxed at only 14.165 per cent as against a tax of 20.6 per cent, or 30.9 per cent or 33.99 per cent on bank interest depending upon your tax bracket.

The tax advantage over bank FDs grows very marked if you opt for the growth option and a maturity of longer than a year.

Here's how

Upon maturity, the gains from the FMP, which you've held for more than a year, will qualify as long term capital gains. Now, FMPs being income funds long-term capital gains from them would be taxed at the lower of 10 per cent without cost indexation, or 20 per cent with cost indexation.

At 10 per cent tax, the post-tax gains from FMPs will obviously be much more handsome than the interest from bank FDs which will be taxed at up to 33.99 per cent depending the income tax rate relevant to you.

Tax-smart: Double indexation

Double indexation is a neat trick where you hold an investment for a little more than one year but get the benefit of the index multiple of two years. How is this done? Consider the table for the 370-day FMP. (See Table-1).

Table-1: 370-Day FMP       

The FMP is for 370 days, exactly 5 days more than one year. However, check out the date of investment and date of exit. The entry date is 29the of March 2006, i.e. FY 05-06. The date of sale is 3rd of April 2007, i.e. FY 07-08.

By holding the investment a little into the next financial year, an investor can use the facility of Cost Inflation Index for two years. The rest of the table is self-explanatory. The CII usage boosts the purchase cost beyond the sale price due to which the investor suffers a notional capital loss.

Consequently, the entire maturity value is rendered tax-free. The net annualized return remains at 8 per cent without any tax incidence whatsoever.

Welcome to the double indexation tax-smart, ladies and gentlemen!

Last word

Hitherto, income schemes were not a safe bet for investors in times of rising interest rates as their NAVs fall at such times. The advent of FMPs has changed all that.

Therefore, if you are looking for a fixed income avenue that yields a return higher than bank FDs with almost equal safety of capital, adequate liquidity and tax advantage, why aren't you looking at FMPs?

Excerpt from the book:

Taxpayer to Taxsaver (F.Y.  2007-08)

By A N Shanbhag

Publisher: Vision Books

Price: Rs 235

A N Shanbhag is a best-selling author and a very widely syndicated columnist on personal finance and taxation.

(C)  All rights reserved.