Reconsider that Fixed Deposit

"Inflation rears its ugly head again, as RBI prepares to raise interest rates." You hear this all the time, and then wonder why you should bother. Over a year now, we, the retail public have been getting horrendously low deposit rates from banks. And if we got a bank offering us 9% deposit rates, the interest was taxed; and at the highest bracket, our real return was only 6.3%.

I have an emergency fund — 6 to 12 months of expenses — in a safe avenue, but I don't know if this emergency will happen in 1 month or after 5 years. My putting the money in a fixed deposit yields very little; plus, I end up paying tax on the interest. And if I use a longer term deposit, I get hit by a pre-closure penalty if I should have an emergency in the meantime.

So we've got three issues — we don't get the best interest rates, we pay taxes on the interest even if we reinvest it, and we fear pre-closure penalties. Is there a way around this, retaining the same safety as a fixed deposit?

Enter the debt mutual fund. Mutual funds are assumed to have equity exposure, but that is a fallacy; in India, more than 80% of mutual fund assets are in non-equity investments, mostly fixed income products. These invest in markets where money is traded, like call money markets, fixed income derivatives, bond markets; here, what you would get for a 1-year investment with the same bank is likely to be higher than what the bank offers for retail deposits.

In mutual funds, you don't get taxed on any intermediate gains until you decide to sell. Keep the money in for two years? The fund may rack up gains, you don't pay tax. And if you decide to sell after a year, you get the additional benefit of long term capital gains tax, which I'll illustrate with an example.

Let's say you put in 500,000 into such a fund, exit after a year, and get a 9% return. That's Rs. 45,000 of gains. With long term capital gains, you get to "index" the gains; that means, they let you adjust the principal up for inflation. The 500,000 that you invested will be considered as 530,000 (assuming 6% is the announced inflation). Your taxable gain is only 15,000 — and the tax on that is, at 20% currently, just Rs. 3,000.

Compare that with making 45,000 in a fixed deposit — it will be added to your income and taxed; at the highest tax slab, you pay 30% of it, or Rs. 13,500 in taxes.

Now, consider the real world. It's hardly likely you would need the entire 500,000 you have stored for a rainy day. You might need Rs. 50,000 for an operation, or Rs. 100,000 to cover an emergency, but not the full amount. With a mutual fund, you can draw only a little bit at a time, without a penalty — and while certain fixed deposits do allow you early partial exits through a "sweep-in" facility, but most banks have started to charge a penalty for early exits.