Fenil's Library

Tax-saving FDs merit more than a look

Though the rates appear lower than on other FDs, the real effective returns are much higher

Sandeep Shanbhag

The recent liquidity infusing measures taken by the Reserve Bank of India saw some banks lowering their rates for advances, including those for home loans. If interest rates for advances fall, it is but obvious that deposit rates, too, will follow.

Consequently, investors are rushing to lock in their funds before these special deposit schemes that offer higher rates permanently go off the shelf.

Past columns have discussed alternate investment avenues such as gold and Nabard bonds, amongst others. However, if it is indeed the Bank FD that is the preferred instrument, then I suggest investors stop worrying about the discontinuance of the high yielding deposits and instead focus on tax-saving fixed deposits that offer the Sec 80C deduction. This is in spite of the fact that these tax-saving FDs offer a rate that is prima facie lower (around 9%) than their plain vanilla counterparts, where the rate can even go up to 11% p.a.

Though the nominal return from a tax-saving FD, per se, seems low, the real effective rate is much higher. In case of individuals who fall in the 30% tax bracket, the effective return is as high as 16.67% p.a.

This is primarily because of the tax deduction. Remember that the initial investment saves you tax. And since a penny saved is a penny earned, the saving in tax payable works akin to having invested that much lesser in the first place. For example, let us assume that an individual deposits Rs 1 lakh in a fixed deposit u/s 80C and he is in the 30% tax bracket. This means, because of his investment, his tax outgo will be lower by Rs 30,000 (Rs 1 lakh x 30%). In other words, he will be receiving an interest of Rs 9,000 (9% of Rs 1 lakh) on an outlay of just Rs 70,000 (Rs 1 lakh — Rs 30,000). This, as we shall see, jacks up the effective return.

Consider the following table:

Date     Interest         Cumulative

amount     (Rs)         (Rs)

Jul 1, 08              —        1,00,000

Dec 31, 08        4,500   1,04,500

Jun 30, 09       4,702   1,09,202

Dec 31, 09       4,914   1,14,116

Jun 30, 10       5,135   1,19,251

Dec 31, 10        5,366   1,24,618

Jun 30, 11        5,607   1,30,226

Dec 31, 11       5,860   1,36,086

Jun 30, 12        6,123   1,42,210

Dec 31, 12       5,759   1,47,969

Jun 30, 13        5,992   1,53,962

It is assumed that a deposit of Rs 1 lakh is made on July 1, 2008. The deposit matures after 5 years, i.e. on June 30, 2013. Interest is payable @9% on a half-yearly basis. The depositor has opted for the reinvestment of interest option and hence the interest is not paid out and accumulates. The second column specifies the interest earned every six months and the last column contains the cumulative deposit figure for each half year.

This is very similar to National Savings Certificate (NSC VIII) as far as the structure is concerned. In case of NSC VIII, the interest accumulates and is not paid to the investor every year. The interest that accumulates is treated as invested in NSC VIII. Hence, it qualifies for an exemption under Section 80C for the first five years. In the last year, the interest is handed over to the investor and does not qualify for a deduction and therefore is taxable. Tax experts are of the view that if the investor opts for a reinvestment of interest option in case of fixed deposits, the accumulated interest would also be eligible for a tax deduction under Section 80C, as it is in case of NSC VIII.

Given this, the interest for the first four years is tax-free as it is deemed to be reinvested. Only the interest for the last year is taxable and the tax rate is 30%. (As can be seen in the table, the interest earned in the last year is less than the previous years because it is taxable at the rate of 30%). Given this, the maturity amount works out to Rs 1,53,962 at the end of five years.

An initial investment of Rs 70,000 (as explained earlier), more than doubles in five years and grows to Rs 1,53,962. The effective return on this works out to be 16.67% per annum and that too net of tax. Now, how many fixed income investment options give you that kind of return?

 

The following are the net effective rates for the various tax slabs:

10%                 20%                 30%                 33%

11.34%            13.79%            16.67%            17.63%

The above numbers should make even those investors who reject fixed income investments for potentially higher returning equity-oriented products sit up and take note. Because, this is like saving tax and getting paid for it.

However, as in all good things, there is a caveat. Readers should note that the above effective rates work out to be so high because there is a tax deduction available on the amount invested, but the maturity amount is tax-free. That is as of now. Once the exempt-exempt-taxed (EET) system of taxation is put into place, the maturity amount would become taxable, thereby bringing the effective return down. However, this would apply to all other instruments, too. Also, EET isn’t coming anytime soon, especially not in a Budget being presented before elections. Lastly, there is a very good chance that when EET is indeed put into place, it would be on a prospective and not on a retrospective basis, which means that it would not be applicable to investments made already. A clarification on this front will benefit the investor community immensely.

sandeep.shanbhag@gmail.com