Tax-saving fixed deposits versus tax-saving mutual funds (ELSS)
weighing scale with ELSS and FDs showing that tax-saving mutual funds (ELSS) are the better way to save on taxes

In order to save on tax, a go-to option for many is to quickly invest in a bank or post-office tax-saving fixed deposit. It may not really be the wisest move on your part.

Deposit pros and cons

You would argue that one, you are assured of the return you earn in a bank or post office fixed deposit. Two, there is no risk that you lose on the capital invested. Three, it’s not a very cumbersome process – its just a matter of going across to your bank (or hopping over to your laptop), or the nearest post office to open a fixed deposit account. There is no contesting these pros.

But on the flip side, the interest earned on the deposit is subject to tax at your applicable slab rate. This will bring down the overall returns made on the investment, and is felt more, obviously, for those in the higher tax brackets. Say, for example, you invested in a tax-saving bank fixed deposit in April 2010. The interest rate you could have earned was around 8.75 per cent. Post tax, the return would have dropped to 8.2, 7.4, and 6.6 per cent in the 10, 20, and 30 per cent tax brackets (assuming quarterly compounding).

A post-office time deposit in the same period would have returned 7, 6.3 and 5.6 per cent, post taxes, assuming quarterly compounding. Right now, post office time deposit interest rate at 8.5 per cent is slightly higher than many bank tax-saving deposit rates, which range between 7.5-8.5 per cent.

The second potential problem with tax-saving FDs is that once the fixed deposit matures, it has to be reinvested if you are to build wealth and prevent yourself from spending it all. If interest rates are in a downward cycle, you run the risk of earning lower returns.

Tax-saving funds

Now, note one important point. Because bank or post office fixed deposits are locked in for five years, it follows that you have a longer-term investment horizon. You also do not require this money any time soon.

Given this, you can afford to participate in equities (i.e., stocks), an asset class that delivers superior returns over the long term. Equity linked savings schemes (ELSS, or tax-saving mutual funds) allow you to invest in equities and earn tax breaks at the same time. Tax-saving funds make for better wealth building and returns than fixed deposits.

For one thing, as mentioned earlier, equity is a superior asset class. Continuing the example above, Rs 20,000 invested in a bank fixed deposit in April 2010 would have grown to Rs 30,830 at the end of five years, assuming quarterly compounding. A post  office time deposit would have given even lower at Rs 28,998. The same Rs 20,000 invested in tax-saving funds would have swelled to Rs 38,985, on an average, in the same period.

Two, the gains made on this investment is not taxed; equity mutual funds don’t have capital gains tax if held for more than one year. So while the fixed deposit return would have dropped as explained above, the tax-saving fund return would have stayed put at an annual 14 per cent. Dividends earned on the mutual fund are also free of tax.

Yes, stock market investments involve higher risk and there is the uncertainty of return. But the long-term horizon mitigates a good part of the risk of losses. Those in their 20s and 30s can certainly afford to take on higher risk in order to earn higher returns. Investors in their 40s and 50s can also invest in tax-saving funds, but in smaller amounts.

Sticking to quality funds with strong performance records can also reduce risk of poor returns. The tax-saving funds on offer also represent a good mix of high risk and moderate risk investment styles, so you can find a fund that suits your risk appetite. Go here for a list of the best tax-saving funds to invest in.

Bottom-line

The amount of deduction available under Section 80 C, at Rs 1.5 lakh is sizeable. For many, it also forms a good chunk of annual investments. And the purpose behind investing is to fulfil life goals such as educating your children or building a kitty for retirement. So why not be smart about where these investments go?

Bhavana Acharya

About the author:

Bhavana Acharya is a Mutual Fund Analyst at FundsIndia.com. She holds a degree in management, with a specialisation in finance. Bhavana has been researching funds, markets, sectors and companies for the last seven years.
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