Home / Money / Personal Finance /  The real returns from your fixed deposit may surprise you

Bank fixed deposit (FD) holders have seen their wealth erode in the past one year. Low interest rates combined with high inflation have turned the real rate of return on FDs negative or abysmally low for many investors.

Interest rates offered by big banks such as SBI, HDFC, ICICI among others on 3-year to 5-year fixed deposits ranges from 5% to 5.3%. Rates for senior citizens are higher by 20-60 basis points. This is the lowest interest rates have been in almost two decades. On the other hand, inflation has been floating around 5-6%.

“Interest rates in India and across most major economies are at historically low levels due to measures taken by global central banks including the RBI to support economic growth in the aftermath of the pandemic. Due to a combination of these monetary measures and fiscal support provided by governments, economic growth has rebounded reasonably well, resulting in inflationary concerns," said Dhaval Kapadia, director - managed portfolios, Morningstar Investment Advisers India.

Further, investors often ignore the impact of tax on final returns from fixed deposits. Interest from fixed deposits is fully taxable, which means the higher the tax slab, lower will be the return.

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Let us understand the impact of tax and inflation on returns on FDs with an example.

For an investor in the tax slab of 30% (without cess and surcharge), a 3-year FD with an interest rate of 5.5% will yield 3.79% post tax. Now, seeing that consumer price indices (CPI) inflation is pegged at 5.3% for FY22 by RBI, the actual return on the FD is essentially about -0.9%.

SBI in a research paper released last month had suggested that it’s time to revisit the taxation of interest on bank deposits with the real rate of return on bank deposits remaining negative “for a considerable period of time". Till then, experts recommend that investors should look at other fixed-income instruments and low-risk debt products that are tax-efficient and capable of delivering better returns compared to fixed deposits.

Think tax before returns

Prableen Bajpai, founder, FinFix Research and Analytics, said picking small savings investment options as per one’s tax slab can make a lot of difference to the final returns for an investor.

For instance, post office time deposit and national savings certificate (NSC) offer slightly higher interest rate of 100-120 basis points compared to FDs. However, the tax treatment on interest of both the options is same as FDs.

Deduction up to 1.5 lakh on a deposit can be claimed under Section 80C for NSC and 5-year deposit. For this reason, most post office savings schemes are not very different from FDs for those in higher tax brackets.

As a thumb rule, investors in higher tax brackets should avoid products where taxation is at the income-tax slab level, said Bajpai.

She suggested investors must look beyond fixed-income products for better tax-efficient products. “Broadly, a combination of arbitrage funds and debt mutual funds can work for investors who are in the higher income slab. While arbitrage funds offer equity taxation, debt funds offer indexation benefit if held for three years."

Debt funds are the best bet for a long-term horizon

Debt mutual funds are a clear winner among all the debt investment options for a longer investment horizon squarely from taxation perspective, as per financial planners.

In the case of debt funds held for over three years, indexation benefit reduces tax considerably. Long-term capital gains on debt funds are taxed at 20% with indexation, which raises the purchase price after considering inflation during the holding period. This brings down the effective tax to 6-7%. Short-time capital gains on debt funds are taxed at tax slabs.

“Investors subject to higher tax slabs can consider debt funds in categories such as banking and PSU, corporate bond and medium to long duration funds where the yields are marginally higher than FDs and returns would be subject to lower tax rates for holding periods of three years and above," said Kapadia.

Debt funds are capable of delivering superior returns than traditional fixed-income instruments; however, investors should note that they carry risk, albeit low, as they are market-linked.

Even though the low interest rate regime is proving to be difficult for safety-seeking investors, one cannot move to risky instruments in search of returns, said Suresh Sadagopan, MD and CEO, Ladder7 Wealth Planners.

Seniors most impacted

Senior citizens are feeling the pinch of negative real returns on FDs the most as most of them park the bulk of their retirement funds in FDs and rely on interest income from them for their regular expenses.

Santosh Joseph, founder and managing partner, Germinate Investor Services LLP, said it is time senior citizens looked beyond FDs and considered spreading their retirement funds across fixed-income and low-risk investment options.

“They can utilize government-backed schemes like Senior Citizen Saving Scheme (SCSS) and Pradhan Mantri Vaya Vandana Yojana (PMVVY) to get better outcomes."

Currently, SCSS is earning the highest interest among all government-backed schemes at 7.4%. The scheme ensures regular flow of income in retirement as the interest amount is paid quarterly to the account holder. Though interest on SCSS is fully taxable and also subject to TDS, the principal is available for tax deduction up to 1.5 lakh under Section 80C.

PMVVY comes with a longer lock-in of 10 years. The biggest upside is that the scheme offers a guaranteed pension to retirees on the basis of rate fixed at the time of starting the scheme. The interest rate on PMVVY is revised annually by Life Insurance Corporation of India (LIC), with the rate for the current fiscal fixed at 7.4%.

Reserve Bank of India floating rate bonds are another option, which are offering 7.15% return currently. The interest is paid every six months and is not cumulative.

“Those in the higher income slab can use the tool of systematic withdrawal plan (SWP) from debt mutual funds to reduce tax liability. Investors who are looking to manage household investments with their requirement corpus must have 10-25% of the portfolio (as the case may be) in equity-oriented products to ensure some growth in the corpus for the coming decades," said Bajpai.

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