The Most Authentic Guide on Personal Finance and Investments


Words of Wisdom : "No matter how great the talent or efforts, some things just take time. You can't produce a baby in one month by getting nine women pregnant." ~ Warren Buffett

How to earn tax-free risk-free income

When you "directly" invest in bank deposits, bonds, debentures, company deposits, etc., you have to pay tax
a) as per your income tax slab rate and
b) on the entire interest earnings.

When you "indirectly" invest in the 'same products' through a debt mutual fund, for a period more than 3 years, you have to pay tax
a) at the rate of 20% but
b) only on the net earnings, after applying indexation on the cost of purchase.


Suppose you belong to the 20% tax bracket and you invest Rs.1 lakh in a fixed deposit @8% p.a. interest that will give you Rs.1.26 lakhs after 3 years. Then,
- On direct investment, you will have to pay 20% tax on Rs.26,000 = Rs.5,200
- On indirect investment, you will have to pay 20% tax on Rs.6,900 = Rs.1,380 (assuming 6% p.a. inflation indexation benefit)

Your effective tax liability, therefore, works out to a mere 5.31% vis-a-vis 20%.

And, if you fall in the highest tax bracket, you are much better off paying only 5.31% tax vis-a-vis 30%. In fact, even those in the 10% tax bracket, end up saving almost half of their tax outgo.

Clearly, indirect investment results is mega tax savings (unless you are in the Nil tax slab).

By the way, in the above example, I have assumed an almost ideal scenario; where the rate of interest (at 8%) is 2% higher than the rate of inflation (at 6%). The reality in India has, however, been less idealistic. On many occasions this gap is much narrow and hence still lower tax liability. In fact, inflation being more than the interest rate, is also quite common. Thus, on many occasions, you will end up with a capital loss and hence zero tax.

In short, with debt funds you can earn "practically" tax-free returns, if invested for at least 3-5 years.

When you invest "directly" you are taking risk with one bank or company. If it defaults, your entire investment is gone.

When you invest "indirectly", you are investing across many banks and companies. Even if one or two of them default, a large portion of your investment is still safe and generating returns.

Debt funds, however, face one risk which normal deposits don't i.e. interest rate risk. Daily NAVs of debt funds are linked to the daily bond prices. Daily bond prices, in turn, are affected by daily changes in market interest rates. If interest rates rise, bond prices fall and vice versa. So, if rates rise, you will lose money as NAVs will fall. But you would also gain when the rates fall as NAVs will go up. 

When we talk of at least 3-5 years of investment horizon, markets will undergo many such ups and downs in the interest rates and NAVs. As a result, quite often, this volatility in the NAV gets evened out and the interest rate risk often gets eliminated or minimized.

In short, with debt funds you can earn "practically" risk-free returns, if invested for at least 3-5 years.

That apart, with mutual funds, you enjoy many other benefits such as high liquidity, professional fund management, convenience, day-to-day monitoring etc. 

You are missing out on a golden opportunity, if you don't get over your reluctance to understand mutual funds and appreciate their immense advantages.

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