Many wealthy investors prefer Fixed Deposits over other Investments. They provide a sense of security and guarantee that few other asset classes can. For many, they become like a habit that is difficult to give up.
Tax eats into returnsÂ
Fixed Deposits because of the way, they are taxed are not great vehicles to take advantage of compounding. Interest on Fixed Deposits is taxable at the slab rate of the investor. Taking an example of an investor who invests say, 1 crore in Bank Fixed Deposits, the interest annually would be in the range of 6 to 7.5 lakhs, depending on prevailing interest rates. If the investor is in the highest tax slab of 30%, effective tax rate is 33% (because of 10% surcharge). This results in a tax of 2 to 2.5 lakhs in our example. Net return falls to 4 to 5 lakhs. If we assume the investor buys FDs every year with similar interest rates, then in 10 years one crore grows to between 1.48 crores (at 6% less tax) and 1.63 crores (7.5% less tax).
Now let’s assume the same investor invests 1 crore in Equity Mutual Funds for the same time period of 10 years. Equity Mutual Fund returns are taxed at 10% and tax is applicable only when you exit from them. Assuming the rate of return to be same of between 6 to 7.5%, one crore post tax grows to 1.71 crores to 1.96 crores. Historically, Equity Mutual Funds as an asset class have delivered far superior returns, but we have assumed same rate of return for an apples-to-apples comparison. Here, we can clearly observe how tax eats into returns. For identical rate of return, the investor gets close to 50% more return for investing in an asset class that is tax-efficient.