Interest on Bank Fixed Deposits is taxable as per one's income tax slab rate.
Vis-a-vis this, till Mar 31, 2023 the long term capital gains (holding period more than 3 years) on Debt Mutual Funds was taxed @20% with indexation benefit.
[Note: Like Banks FDs, the short term capital gains (holding period upto 3 years) on Debt MFs was taxable as per one's income tax slab rate.]
Therefore, there was massive tax advantage when a person in the higher tax brackets invested in Debt MFs as compared to the Bank FDs, and held it for more than 3 years.
Sadly, w.e.f. April 1, 2023, this huge tax benefit on Debt MFs is gone. Now, like Banks FDs, the capital gains (irrespective of the holding period) would be taxed as per one's income tax slab rate.
This is a big blow for the Debt Funds.
However, even if Bank FDs and Debt MFs are now at par as far as the taxation is concerned, Debt MFs continue to score over Banks FDs on many other counts.
Therefore, it would still be advantageous to invest in Debt MFs as compared to the Bank FDs.
Let's explore:
1. Deferred Tax Liability
In case of Bank FDs, the tax is payable every year on the interest accrued. So, assuming you do a 5-year fixed deposit with cumulative option, you will have to pay tax on the interest earned every year; even though you will get the interest only after 5 years at the time of maturity.
However, in case of Debt Funds, you have to pay tax only when you redeem your investment. So, assuming you opt for the Growth Option and don't make any withdrawals for say 10 years, you have to pay no tax for these 10 years; even though the value of your investment is going up every year.
2. No loss on early encashment
Suppose you do a 5-year FD. But for some reason you have to withdraw the money after only say 6 months. Then, your interest income will be calculated on the 6-monthly rate of interest and not the contracted 5-year rate of interest. Since short-tenure rates are typically 1-3% lower than long-tenure rates, you will end up earning much lower income on premature encashment of a Bank FD.
With Debt Funds, this is not the case. Whatever increase has happened in the NAV, you will get the same WITHOUT ANY REDUCTION. So, with Debt Funds, you have the flexibility to withdraw your money any time, without worrying about any loss in your interest earnings.
3. No penalty on early encashment
Normally, banks levy a 0.5-1% penalty — over and above the reduction in the applicable rate of interest discussed in point 2 above — in case you encash your Bank FD before maturity.
Most Debt Funds do not charge any such penalty (known as exit load in MF terminology) on early encashment. Some Debt Funds do have an exit load. But this too is applicable for a limited period only (ranging from 1 week to 6 months/1 year). So, typically, if you have chosen your funds judiciously, you can withdraw your money WITHOUT ANY DEDUCTION.
4. Ease of partial withdrawal
Bank FDs generally do not have the option of part withdrawal. So even if your requirement is less, you have break the entire FD. Consquently, you lose a lot with a Bank FD.
There is no such problem with the Debt MFs. You can redeem part no. of units (without any loss of interest or penalty) and the balance units continue to remain invested (and keep growing).
5. Opportunity to claim set-off
Interest earned on Bank FDs is treated as Income from Other Sources. It gets added to your total income and taxed accordingly.
Income from Debt MFs is treated as capital gains. This gives you an opportunity to claim a set-off in case you have made a capital loss elsewhere say in some equity share. Thus, with Debt MFs, you have the the option to bring down your tax liability to the extent you have any loss to set-off.
In short, despite the setback of losing the indexation benefit, many other advantages of investing in Debt MFs continue to give them an edge over the Bank FDs.