Your parents advised you to buy fixed deposits. Is that a good idea?

Amended as on Apr 1, 2023: Please note that as per amendments in Finance Bill 2023, from April 1, 2023, profits made on investments in debt mutual funds are now taxed as short-term capital gains if these funds invest <=35% in equities. This means, debt mutual funds are now taxed as per the income tax rates as per an individual’s income.

Also note that with effect from Apr 1, 2020, Dividend Distribution Tax (DDT) was abolished, and mutual fund dividends were made taxable in the hands of investors. Dividend income is now considered as ‘income from other sources’ and investors need to pay tax on it as per their individual tax slabs.

This article is currently in the process of getting updated, as it was originally written at a time when tax rules were different. Please treat this note as the latest updated tax information in the meanwhile.

FDs are offered by banks and by certain companies. Banks and companies issue FDs according to the prevailing rates of interest. Company FDs generally tend to pay more interest than bank FDs but they can be riskier. While the Deposit Insurance and Credit Guarantee Corporation (DICGC) insures bank deposits up to Rs. 1 lakh, company FDs are insured up to Rs. 20,000 only, under the Companies Act.

About Fixed Deposits

Ratings: Company FDs are rated by various credit rating agencies such as CRISIL, CARE, etc. whereas bank FDs are not rated as they are insured under the Banking Regulation Act of 1949.

Interest rate: Bank FD rates are decided based on directions given by the Reserve Bank of India (RBI) from time to time. Company FDs usually offer 1-3 per cent more than bank FDs.

Tenure: FDs can have a tenure of 7 days to 10 years.

Tax benefits: Interest earned on bank FDs is tax-free to the extent of Rs 10,000 per financial year. Beyond this amount, interest is fully taxable. The rate of tax depends on the tax bracket you fall in (10%, 20% or 30%). Interest earned on company FDs is taxable.

Liquidity

Fixed deposits are generally illiquid; this means you can’t withdraw the money till the tenure is over. Banks will not levy any penalty in case of premature closure of a deposit; however, you are paid interest applicable for the period the deposit is retained (and not for the entire period that you planned to hold the deposit). In case of a 5-year bank FD offering tax benefit under section 80C, the money can’t be withdrawn before 5 years.

In case of company FDs, you can’t withdraw money from a fixed deposit before 6 months. Even after this period, you may have to pay a substantial penalty and there is a lot of paperwork necessary to withdraw your money.

Real Returns

When investing in a fixed deposit, you should carefully consider real returns (returns minus inflation rate minus tax rate) and not just the returns mentioned on your FD receipt.

You can understand this with an example:
Let’s say an investor in the 20% tax bracket makes a fixed deposit of Rs.1 lakh for a period of 1 year at 8% p.a. Let’s see how inflation and tax impact the returns from the FD investment.

Impact of taxation
Considering tax at 20% of 8% (interest rate), the tax rate is 1.6% (8% x 20%). The return on the FD after tax is 6.4% (8% - 1.6%).

Impact of inflation
The average inflation rate in the period 1995-2015 was 7.3%. Taking this as the inflation rate, if we reduce this rate from the FD returns after tax, we are actually left with negative returns of 0.90%. In other words, the investor will face erosion in the real value of his capital.

Pros and Cons of Fixed Deposits
Just like every other investment, fixed deposits too have their own pros and cons:

In conclusion, while fixed deposits seem to be safe, secure and attractive, in reality, they are prone to suffer from inflation and high taxation. Company fixed deposits may seem even more attractive compared with bank deposits but have a higher risk. Fixed deposits have a low level of liquidity. Investors would do well to consider debt mutual funds which offer attractive returns, liquidity and more favorable tax breaks.

So why did my parents’ recommend FDs?
Your parents obviously have your best interests at heart and are guiding you with the knowledge they have based on the options available in their time. Also, times are changing and inflation levels today simply don’t allow traditional investment instruments to function in the manner in which they’re supposed to- to give assured, real returns!

Remember, habits are difficult to break and if a change is required for progress, it should be embraced as early as possible. Given the information on FDs that you now have, won’t you want to speak to your parents and ask them to not depend so heavily on FDs themselves?