The interest earned on fixed deposits is exempted up to Rs 10,000 and any interest earned above that will be added to the taxable income.
Returns are a byproduct of investment decisions. Before considering the returns on any investment, it is prudent to analyse how and why some products provide higher or lower returns. It is also wise to consider the comfort, or the quality of sleep, we get after making investments. If the investment has features that are likely to cause nightmares or severe mood swings, then, it is certainly in the high-risk category. Fixed deposits (FDs) in banks are not entirely exempt from this segment. Some FDs, especially those in some small, private or cooperative banks, may offer higher interest rates than others, but these banks carry higher risk of defaults.
Besides risk, the factor that has very high impact on returns, but is easier to analyse and quantify, is taxes. Taxation of returns can turn an otherwise attractive investment into one that provides sub-optimal returns. The impact of tax on returns can be front-ended—the investment made may provide a deduction from taxable income under Section 80C of the Income Tax Act. 80C deductions are available to investors on a range of investments, including a category of FDs that are locked in for five years. The other kind of tax impact is back-ended—on the returns earned on the investment.
The interest earned on fixed deposits (other than tax saving fixed deposits) is exempted to the extent of Rs 10,000 and any interest earned over and above that will be added to the taxable income. Public Provident Fund (PPF) and most life insurance policies offer tax benefits both through deduction from taxable income during investment and by providing tax-free returns.
The objective of the investment is another vital parameter. This would be essentially linked, along with the risk or safety desired by the investor, to the time horizon (the length of time over which an investment is held before it is liquidated) and liquidity (the degree to which the investment can be urgently encashed without affecting the price). An investment targeted at retirement would need to be high in safety and have an extremely long maturity period. Near-term liquidity may be ignored in this case. However, an investment that has a vacation as the objective needs liquidity and may accept risk as a pay-off for higher returns.
A retired or unemployed person needs regular cash flows. Investments that provide only maturity benefits will not be suitable to an investor with such a requirement. Bank FDs are basically structured to provide quarterly interest payouts, with even monthly payments being offered as a variant.
Eligibility to make investment in certain instruments is a limitation to investors. The excellent PPF is not available to foreigners, non-resident Indians or Hindu undivided families. Besides, there is a deposit cap of Rs 1.5 lakh a year per adult in the PPF. The Sukanya Samriddhi Yojana is available to parents of a girl child for investment in the child's name. Investments can be made in the name of girls up to the age of 10 and is capped at Rs 1.5 lakh a year. The Senior Citizens Savings Scheme is available to, barring a few exceptions such as a person who has been superannuated or has opted for the Voluntary Retirement Scheme, those above the age of 60. Investment is capped at Rs 15 lakh per person.
With the belief that investors target bank FDs with the objective of high safety, we suggest alternatives with similar characteristics, providing superior returns.
PPF: An investment that every resident Indian should have. An annual or monthly PPF deposit enables the investor to build long-term financial assets with tax efficiency (deduction under 80C at investment) and tax-free income—the entire principal and interest are tax free. A positive is the long-term nature of the PPF, 15 years, extendable perpetually by 5 years at a time. Opening an account in the name of a minor will help provide liquidity early in their working life and also inculcate a saving habit. A minor’s account is linked to a parent/ guardian with the combined deposit by them not exceeding Rs 1.5 lakh a year.
Sukanya Samriddhi Yojana and Senior Citizens Savings Scheme: As already explained, these have restricted access because of qualifications limiting those who can invest. Both schemes pay a preferential rate of interest that is 0.5 per cent higher than the PPF. The investments qualify for tax benefit under section 80C.
Sukanya Samriddhi Yojana is limited to two children. The account has a maturity period of 21 years, but the balance may be withdrawn when the child turns 18. The interest and maturity amount are tax free.
The Senior Citizens Savings Scheme provides for the cash flows that matter to a senior citizen by paying quarterly interest, but the interest is taxable.
Debt schemes of mutual funds: These schemes invest in government and corporate debt. The risk is limited to default in the bonds held by the fund, which can be reduced by checking the portfolio for risky investments, or investing in funds that are highly rated. The interest earned is normally higher than bank FDs. There is short-term volatility to be dealt with, and investment in these funds must be for at least three years. An investment of over three years entitles the investor to a lower income tax rate, which increases post-tax earnings to very attractive levels. There is a dividend option that provides a small benefit to short-term investors in the highest tax bracket. The added advantage of investing in debt funds is that their returns increase as interest rates in the economy drop, which is a situation that is likely in India at present according to analysts.
Bonds and fixed deposits of companies: These pay out at interest rates higher than banks. It is important to deposit money only in highly-rated companies to avoid the risk of default. They are fully taxed at a marginal rate of tax as the interest is added to taxable income.
To sum up, medium to long-term investors can earn higher interests compared to banks, while ensuring the safety of their capital, by investing in these options.
The writer is CEO and founder of Right Horizons.