Debt Funds Versus Fixed Deposits: Which is Better?

As per the new debt fund tax rule, debt funds with 35% less exposure to domestic equities, irrespective of the holding period, will be taxed as per the investor’s tax slab. 

For instance, if an investor invests in debt funds on or after April 1, 2023, and falls under the 30% income tax bracket, the capital gains will be taxed at 30% without indexation benefits. 

With this move, it is being stated that the main advantage of debt funds over bank fixed deposits (FDs) is lost now. So, let’s find out more. 

Debt mutual fund investments generally comprise securities like corporate bonds, government securities, treasury bills, commercial papers, etc.  

As compared to equity mutual funds, debt funds are significantly stable, yield regular income, and have a low to moderate risk, depending on the sub-category.  

The fact is that debt funds invest in debt products that offer predictable returns and they carry much lower risk and are less volatile. Generally, debt funds offer a 7-9% rate of return. 

With a systematic transfer plan (STP), debt funds offer flexibility to an investor to spread out the risk of investing in the stock market.

On the other hand, FDs, also referred to as term deposits or time deposits, are investment tools offered by banks and non-banking financial companies (NBFCs) and banks. Generally, FDs offer a rate of return of 5-8%. 

An investor can deposit a lump sum amount for a specific period. The tenure of FD can range from seven days to 10 years or more (this may vary from one bank to another).

On the liquidity front, debt funds and fixed deposits are highly liquid. 

In the case of bank FDs, interest income is fully taxable. Besides, banks also levy tax deducted at source (TDS) on the interest paid on FDs. Suppose, if you fall under the 30% income tax bracket, you would have a tax liability of 30% on the interest paid on FDs. 

However, in the case of debt funds, tax liability arises only at the time of redemption. So, if you continue to hold debt funds till the age of retirement, and let’s say, the income tax bracket has come down to 5-10% or more, the tax liability on debt funds capital gains would be reduced accordingly.