A significant proportion of retirees in India rely on Fixed Deposits to generate an income that can meet their post retirement needs. With quarterly or monthly interest arriving in their bank accounts, it acts as a sort of pension for many.
But are FDs the only way?
Many retirees choose Fixed Deposits due to the perceived low risk nature of the investment. The fixed interest rate and predictability of income also make this option attractive to them.
There is however a catch. Fixed Deposits are taxed fully and the interest income is subject to tax deducted at source. If you fall in the highest tax bracket then you will end up paying almost 30% of your interest income in taxes. Year after year, this outflow becomes a significant amount. But what if there was a way to earn the same amount in interest but pay far lesser in taxes?
That way is the growth option Liquid Fund.
A Liquid Fund invests in government bonds, deposits or bonds of highly creditworthy companies. Moreover, Liquid Funds invest in short duration securities, which eliminates interest rate risk. This means that in terms of risk, Liquid Funds and Fixed Deposits are almost at par.
The way you earn an income from a Liquid Fund is in the form of capital gains unlike the interest income from a Fixed Deposit. Basically, the value of your Liquid Fund goes up over time. On an annual basis the gains are rather similar to how much interest a Fixed Deposit of the same value would have generated.
Because of the way a Liquid Fund grows, it is treated differently from a tax perspective. Since the gains are capital gains, these are added to your income for the first three years and after the third year the investment becomes long term and the gains as well. This means the gains are now subject to indexation. This significantly reduces the tax liability on the gains.
Everything has a catch
While Liquid Funds are much better from a tax perspective, due to the nature of mutual funds, the gains change on a day to day basis. This is unlike the pretty fixed way interest is credited to your bank account regularly. Our past analysis suggests that, you are better off with liquid funds, over Fixed Deposits, even adjusting for the daily changes.
In a Liquid Fund, there is no income and you need to sell down the holdings to the extent of income required. This approach also applies only to growth option of Liquid Funds. This requires some effort, or to work with someone like Scripbox which can manage this process for you.
No lock in
Most long term Fixed Deposits involve a lock in of 3-5 years. This means if you needed the capital in case of an urgent need, it would not be available (or there is a penalty). Liquid Funds have no such catch and you can withdraw the entire capital whenever you want.
For those in the highest tax bracket post retirement, Liquid Funds are invariably the better option. The flexibility of withdrawing how much you need is also helpful in cases where the gains are more than what you might actually need.
The lower tax liability after three years and flexibility comes at the price of certain added complexity in terms of managing the investment. However, this is a case of the ends justifying the means, and for most retirees the ends matter a lot.