Invest Smart: Fixed deposits Vs debt mutual funds

Ever since the taxation structure of debt mutual funds was changed where the tax benefits were taken away, there has been a relook at the category. There is a perception that debt mutual funds and fixed deposits are the same because you pay tax as per you income tax slab.

However, there still remain some significant differences between the two investment avenues with debt mutual funds working out to be more beneficial that fixed deposits in certain aspects.

Another factor to consider is the growth versus dividend options of debt mutual funds.

Harsh Roongta, Fee Only Investment Advisers LLP,
explains the concept of growth vs dividend option of debt mutual funds using the the analogy of a 100,000-litre water tank representing one's mutual fund investment and 6,000 litres of water supplied annually by the municipal autho­rities as the income generated by the fund.

One could either have the 6,000 litres of municipal water delivered directly home, which would be akin to the fund’s dividend option. Alternatively, one could add the 6,000 litres to the tank (similar to the growth option) and then withdraw from it. The tank would now contain 106,000 litres. When in future he withdraws 6,000 litres from the tank, 94.34 per cent (100,000/106,000) would be his own water while 5.66 per cent (6,000/106,000) would be municipal water.

On choosing the dividend option, one would need to pay tax immediately on the 6,000 litres of municipal water delivered home.

But in the growth option, withdrawing 6,000 litres from the tank that contains a mix of one's own and municipal water, only 340 litres (or 5.66 per cent of 6,000 litres) would be municipal water on which one would have to pay tax. The remaining 5,660 litres (94.34 per cent of 6,000 litres) would be one's own water on which they would not have to pay tax. This means one would pay tax on only a fraction of the water consumed, even though the amount consumed would be the same as in the dividend option. The amount of water remaining in the tank would also be the same at 100,000 litres.

"The structural benefit of a growth scheme — of tax being charged on a lower amount — persists. This will allow investors to benefit from lower tax payments indefinitely, as long as the withdrawals are equal to or less than the income added during the year.", says Roongta.

Fee Only Investment Advisers LLP is a SEBI registered Investment advisory firm.