MUTUAL FUNDS are very TAX FRIENDLY

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Savers would do well to understand the workings of the tax advantage that mutual funds have over bank deposits

A few months ago, I had written an article on replacing bank fixed deposits (FDs) with fund investments.

However, a lot readers don't really understand how mutual funds attract less taxation, so here's a detailed explanation of the entire mechanism.

In three years, falling interest rates have knocked off around 40% from the annual income that a FD would yield. That's a shocking decline. People generally don't do the math of returns correctly. Each step in the decline of FD rates appears small. They're generally around 0.25% to 0.5%, which sounds trivial.

However, the actual reduction in income is much more significant. For instance, a decline in the interest rate from 7.5% to 7% is a reduction of 7% in the income that the deposit generates. This adds up fairly quickly. Over the past three years, you would have seen a 2.5% decline in the rate of interest that you earn from your FDs, from 8.75% to 6.25% . However, in terms of actual income, that's a reduction of 40%.

The logical way to deal with this issue is to shift your money from FDs to mutual funds. Mutual funds that have a low risk profile would appeal to FD holders. These have rates of return that appear to be only marginally higher than those of fixed income. However, the math works the same way as in the above example. Over the past year, a FD would have yielded 7% interest, which was the rate in late 2016. Over the same period, an average liquid fund, which has negligible risk and variability, would have yielded 7.5%. That's 10% higher in terms of earnings.

However, in addition to this, there's the cherry on the cake: taxation. For investments of less than three years, the taxation is the same for the two options. If you sell off the entire mutual fund investment, the earnings will indeed be taxed in the same way as the FD, that is, by being added to your income. However, if your goal is to withdraw the gains, the tax paid in the case of mutual funds is much less. The reason is simple. Interest is income, while mutual fund returns are capital gains.When you receive interest from a deposit, the entire thing is considered income. However, when you withdraw money from your mutual fund investment, a part of it is the original principal you invested, which is obviously tax-free.

Here's a concrete example. Let's say you invest `10 lakh in a mutual fund. A year later, the value of the investment has increased to `10.8 lakh. Now, you want to withdraw the `80,000 you have gained. Note that out of the investment you hold, 7.4% is the gain and the remaining 92.6% is the principal that you had invested. Here's the key idea: when you withdraw any money, the withdrawal shall be deemed to consist of the gains and the principal in this same proportion, for tax purposes. Therefore, of that `80,000, only `5,926 will be considered gains and will therefore be added to your taxable income. This makes an enormous difference. In an equivalent FD, you would pay `24,720 as tax in the highedt slab. In the mutual fund, you would pay `1,831 as tax.

There are other benefits which fund investors understand but bank depositors seem to be unaware of. There's TDS and annual taxation, for instance. For cumulative FDs, you have to pay tax every year. That's money that won't be earning returns in the future. In the equivalent mutual fund investment, there's no annual tax liability because the gains are not considered income. So the money is available for compounding for as long as the investment is held. After three years, the accumulated amount in the mutual fund will be almost one and a half times that in the deposit, assuming you are in the top tax bracket. For an initial investment of `1 lakh, at the end of three years, the FD will effectively be worth `1.26 lakh while the fund investment will be worth `1.4 lakh.Since the FD tax outgo is split between 10% TDS and the rest paid out directly, the exact rate of return depends on how you account for this tax.

Whichever way you look at it, in these times of falling interest rates, the tax advantages makes the mutual fund alternative twice as attractive.

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