Fixed deposits are among the most popular investment instruments among Indians. This is because they are highly predictable – they are fixed and offer a guaranteed interest over a fixed period. The predictability is especially beneficial if you are looking to reduce the risk exposure of your investment portfolio.
That said, the interest earned on fixed deposits is taxed based on the income tax slab your total income falls under. It could potentially be as high as 30%. An alternative that you can use to reduce your tax liability is liquid funds.
A liquid fund is a mutual fund scheme that invests in government bonds, deposits and deposits/bonds offered by companies with high credit rating. As the underlying investments are in short-term debt, interest rate risk is eliminated. This means the liquid funds and fixed deposits are quite close in their risk profiles.
Liquid funds are considered to be the least risky among the different types of mutual funds. It is because all the investments under such funds are into securities with at least a P1+ credit rating.
Further, the post-tax returns from liquid funds are about the same as from fixed deposit rates. Of course, they vary over time but tend to stay with a percentage point of each other. Though it is important to remember that the returns from liquid funds varies on a day to day basis, and does not provide the predictability that comes from a fixed deposit.
Fixed deposits may have a lock-in period as in the case of tax-saving fixed deposits. Further, if you make a premature withdrawal before the tenure is complete, you will have to pay a penalty in terms of reduced fixed deposit rate. A liquid fund has no lock-in period at all, allowing the deposit to be closer to cash compared to fixed deposit. SEBI allows instant redemption of up to ₹50,000, meaning the amount withdrawn can be in your saving account in a matter of minutes.
It is important to remember that the income from selling liquid fund units is treated as a capital gain for tax purposes. If you stay invested for over three-years, the same is treated a long-term capital gain and can earn the benefit of indexation.
Liquid funds could be a better option if you have a large capital to invest and your income falls under the highest income tax bracket. It is because the savings from the reduced tax liability can be significant.
General advise: Keep the amount required for the next five years in a liquid fund and rest in fixed deposits. It is especially recommended for retirees to balance the risks and earn a good return.
In case you would like to use your entire corpus to generate a regular income, a fixed deposit may be a better option among the two. The ease of operation can also play a role in the selection you make, especially for senior citizens. The additional 0.25% to 0.5% interest rate available to senior citizens on fixed deposits is attractive as well.
Liquid funds have a better tax treatment compared to fixed deposit, especially if you fall under the highest tax bracket. That said, the predictability of returns and ease of operation can still make FD a better option for many.