Bank FDs: When less is more

Only investments made before the Direct Tax Code will enjoy tax advantage on maturity amount.
Reserve Bank of India’s (RBI) pause on the rate hike front has been a welcome move. But, if interest rates for advances were to fall, it is but obvious that deposit rates too will follow. Consequently, senior citizens are rushing to lock-in their funds before high yielding bank fixed deposit (FD) schemes go off the shelf. However, if one prefers bank FDs, then he should focus on deposits, with a lock-in period of five years, that offer deduction under Sec 80C of the Income Tax Act.

The nominal return of around nine per cent from a tax saving FD, seems low when you compare it with instruments that offer around 10.5-11 per cent per annum (p.a). Yet, the real effective rate is much higher. In case of individuals who fall in the 30 per cent tax bracket, the effective return is as high as 14.15 per cent p.a.
This is primarily because of the tax deduction. Remember that the initial investment saves you tax. And since a penny saved is a penny earned, the saving in tax payable works akin to having invested that much lesser in the first place. For example, let us assume that an individual in the highest tax bracket, deposits Rs 1 lakh in a fixed deposit under section 80C. What this means is that because of his investment, his tax outgo will be lower by Rs 30,000 (Rs 1 lakh x 30 per cent). Or in other words, he will be receiving an interest of Rs 9,000 (9 per cent of Rs 1 lakh) on an outlay of just Rs 70,000 (Rs 1 lakh – Rs 30000). This, as the table shows, ups the effective return. It is assumed that a deposit of Rs 1 lakh made on 1 January 2012 will mature after five years (31.12.16) and earn an annual interest of 9 per cent.

PAY-BACK TIME FOR INVESTORS*
Date	Annual pre-tax	Annual post tax	Annual closing
	Interest	interest	balance
01.1.12	-	-	100,000
31.12.12	9,000	6,300	106,300
31.12.13	9,567	6,697	112,997
31.12.14	10,170	7,119	120,116
31.12.15	10,810	7,567	127,683
31.12.16	11,491	8,044	135,727
(Amount in Rupees) *In the 30 % tax bracket

This is very similar to National Savings Certificate (NSC VIII) as far as the structure is concerned. In case of NSC VIII the interest accumulates and is not paid to the investor every year. The interest that accumulates is treated as invested in NSC VIII. Hence it qualifies for an exemption under Section 80C for the first five years. In the last year, the interest is handed over to the investor and does not qualify for a deduction and therefore is taxable. Tax experts are of the view that if the investor opts for a reinvestment of interest option in case of fixed deposits, the accumulated interest should also be eligible for a tax deduction under Section 80C as it is in case of NSC VIII. However, since there is no clarification from the tax authorities on this issue, in the example, the interest is treated as fully taxable.
An initial investment of Rs 70,000 (as explained earlier), grows to an after-tax Rs 1,35,727. Consequently, the effective return works out to be 14.15 per cent p.a for those in the 30 per cent tax slab. For those in the 10 and 20 per cent tax slab, the return works out to be 16.08 p.a. and 15.12 per cent p.a respectively. These numbers should make even those investors who reject fixed income investments for potentially higher returning equity oriented products sit up and take notice. Because, this is like saving tax and getting paid for it.
With a dearth of good fixed income avenues, the tax saving FD offers a high effective rate.However, this window will be open only until the Direct Tax Code (DTC) is introduced. Scheduled to be operational with effect from April 2012 , chances are it will be postponed. Under the DTC, the Exempt Exempt Taxed (EET) system of taxation would be applicable. It is a tax system where an investment and interest, in a tax saving plan is deductible from income but the maturity amount is taxable. The tax saving FD has an effective rate since the tax deduction is available on the invested amount and the amount on maturity is completely tax-free. Under EET, the maturity amount will be taxable rendering the effective rate equal to the coupon rate of 9 per cent (post tax 6.3 per cent p.a.)
However,for investments made before the advent of DTC, the maturity amount will continue to be tax-free even in the DTC regime. So do make hay when the sun shines.