Accrual Debt Funds better than Bank FDs





Dinesh Sethi (name changed) was finding it tough to take time out from his busy schedule to arrange for monthly expenses for his daughter, who was studying in another city. Often while trying to arrange for her expenses, he found his budget was going haywire.Sethi thought the best solution for him was to allocate about Rs 20,000 from the interest that accrued to his bank fixed deposits for his daughter's monthly education expenses. To be free of the recurring stress, he wanted to continue this for the next three years.

Sethi's search for solution took him to the neighbourhood bank, which had a neat answer to his query . He needed to open a fixed deposit account of Rs 27 lakh, which would pay him at 9% interest per year with a monthly payment of interest to provide for his daughter's education expenses. The arithmetic was indisputable but just to reassure himself, Sethi came to us for a second opinion.

The arithmetic was indeed fine except for an omnipresent element of 30.90% income tax that Sethi needed to pay on the interest received from the bank. He actually needed to make an FD of approximately Rs 39 lakh, since the post-tax return on the FD would be a feeble 6.20%, he being in the highest tax bracket.

We offered him an alternate tax efficient solution, which is investing in an accrual debt fund (with an exit load of 0.50% up to one year) with a monthly `Systematic Withdrawal Plan (SWP)' that pegged his investment at much lower amount of Rs 28 lakh

Accrual funds are those debt funds that hold short to medium-term debt instruments in the portfolio and deliver returns similar (generally better) to medium term bank FDs. SWP is a facility under which every month on a pre-specified date, a fixed pre-specified amount is withdrawn from the designated mutual fund scheme and credited to the investor's account. As shown in the table, debt mutual funds would need far lesser investment than a bank FD to achieve the same objective.

When we explained the rationale behind investing in an accrual debt fund and the related tax efficiency angle, Sethi was convinced about the advantage of investing in mutual funds. The simple logic here is that interest on FDs is included in taxable income and is wholly exposed to the marginal rate of taxation.

 

Whereas, in case of investment in the growth option of an accrual debt fund, the units remain the same and the NAV increases over time. When one redeems an amount equivalent to the gains from the investment, units equivalent to the redemption amount (at the NAV on the redemption date) are redeemed. However, for tax purposes, the capital gains is not equal to the withdrawal amount, rather it is only the increase in the NAV in respect of the units withdrawn. This creates enormous tax efficiency .

 

 

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