Debt mutual funds or FDs: What should you pick given RBI status quo?

With the Reserve Bank of India keeping the key repo rates unchanged at 6.50 per cent on Thursday,  mutual fund experts have advised investors to opt for medium-duration debt funds. Meanwhile, the pause in the repo rate hike coupled with surplus liquidity in the banking system due to the return of Rs 2000 notes, could result in bigger banks with adequate deposit mobilization to halt their fixed deposit (FD) rate hikes. This implies that those looking to park their funds could also now book their FDs for longer tenures if they are being offered at attractive yields.

What should investors opt for in this scenario?

What is Fixed Deposit

Fixed deposits are a type of savings account where banks offer a fixed interest rate and a fixed maturity date, and the institution guarantees the deposit. They are typically  low-risk investments suitable for individuals who want to earn a fixed return on their savings.Fixed deposits are not associated with the market and are unaffected by stock market volatility. Generally, FDs offer a rate of return of 5-8%.

What are debt mutual funds

Debt mutual funds are mutual funds that invest in fixed-income securities such as bonds and debentures that have the potential for higher returns than fixed deposits but also bring more risk. The returns on debt funds are not fixed and are subject to market fluctuations. Since debt mutual funds are market-linked, they depend on market variations (bonds, etc.).  Generally, debt funds offer a 7-9% rate of return. 


The provision of indexation benefit in debt MF was removed from April 2023

From April 1, 2023,  taxation rules for debt mutual funds changed. According to the new tax rules, indexation benefits will not be available to “specified debt mutual funds” – where equity investments do not exceed 35% of their assets under management. These mutual funds will be taxed in the same manner as bank fixed deposits.

The Union Budget 2023  said capital gains arising from sale or transfer of “specified mutual funds” shall be treated as short-term capital gains. These gains will be taxed at the income tax rates that are applicable to the taxpayer’s income, irrespective of the holding period. This essentially means that Debt funds have lost the long-term capital gains indexation benefit. For instance, if an investor invests in debt funds on or after April 1, 2023, and falls under the 30% income tax bracket, the capital gains will be taxed at 30% without indexation benefits.

In the case of bank FDs, interest income is fully taxable. Besides, banks also levy tax deducted at source (TDS) on the interest paid on FDs. “Suppose, if you fall under the 30% income tax bracket, you would have a tax liability of 30% on the interest paid on FDs,” explains ClearTax.   Every year, the fixed deposit interest is added to the taxpayer’s income and taxed at the investor’s tax slab. Each fiscal year, a TDS of 10% is imposed on FD interest over Rs 10,000.

Despite losing this indexation benefit, some investors may still opt for debt mutual funds.

The remaining advantage of debt MFs is non-application of TDS

The interest earned from a bank FD is taxable every year irrespective of whether it is credited into the savings account or not. For example, in the case of cumulative bank FDs, the interest is paid to the depositor  only at the end of the maturity period, but the interest accrued is taxed every year. But the capital gains tax incidence on debt mutual funds occucers when they are redeemed or transferred to a different mutual fund scheme.

Hence, no capital gains tax will be payable during the holding period. If you continue to hold debt funds till the age of retirement, and your income tax bracket has come down to 5-10% or more, the tax liability on debt funds capital gains would be reduced accordingly.  Hence, debt funds are a great option if you  want to postpone your taxes.

“From 1 April, 2023  all debt investments became chargeable to tax at normal slab rate applicable to assessee instead of erstwhile status enjoyed by them @20% u/s 112. This was the primary reason why investors preferred debt investments which have gone now. This change has brought the bank FDs & Debt mutual funds at parity. Considering this change, if the investors want high volatile return and have accumulated capital gain losses for the purpose of set-off, it is advisable to  invest in debt investments instead of FDs, which offer fixed rate of return, said Maneet Pal Singh, Partner, I.P. Pasricha & Co.

“Investors no more have tax arbitrage for investing in debt mutual funds as against bank deposits.  However, from a practical stand point, investments in debt mutual fund can avoid certain unwarranted compliance difficulties that tax payers would otherwise face. While returns on mutual funds are taxable only on their redemption, interest on deposits becomes taxable even before the money reaches the investor. 

Though a depositor can defer offering the accrued interest to tax till the time the interest is actually credited, banks deduct TDS on accrued interest.  Carrying forward the TDS credit and having it netted off in the future is a practical nightmare, more often resulting in the credit being denied in the future period,” said S Sriram, Lakshmikumaran &Sridharan attorneys.

 So if one generates a return of Rs10,000/- upon an investment of  Rs 1,00,000/- through debt funds, the entire amount of Rs  1,10,000/- is paid back to the investor without any deduction of TDS on return of Rs 10,000/-. whereas, in FDs, tds is deducted on the return generated, explained Sandeep Bajaj, Managing Partner, PSL Advocates & Solicitors


“From FY 2023-24, gain or loss from debt MF will always be short term. As per the income tax provisions, short-term loss from any capital asset can be set off against short-term as well as long-term gains from any capital asset. But in case of gains from debt MF, investors have to be careful. Short-term gains from debt MF can be set off against short-term loss from any class of capital asset, said CA Mahima Vachhrajani.

This means that if you have long-term capital losses from other assets, such losses cannot be set off against the short-term capital gains arising from debt mutual funds. Long-term capital losses can be set off against long-term capital gains only.

Rs 10,000/- return generated can be set off against any short term loss of upto Rs 10,000 on capital assets saving income tax on the said return.

Flexibility of Withdrawal

If you want premature withdrawal, a penalty is generally charged by banks if you want to exit your FD investments early. It is also not possible to systematically withdraw money from your FDs.In most debt funds, the money can be withdrawn anytime without any exit penalty. Further, you have the option to automate your money withdrawals every month by setting up systematic Withdrawal Plan.

Charges: There are no direct costs associated with investing in fixed deposits. In the case of bonds, the cost of demat accounts need to be accounted for. Moreover, for debt mutual funds, expenditure ratios can range from 0.2% to 2.25%. It is the fee fund houses charge for handling debt funds. Therefore, regular plans are subject to higher charges.

Which one should you pick?

According to Chaitali Dutta of Personal Finance Advisory, booking an FD in the following situations may be useful:

1) Parking the funds allocated for usage in the next 2-4 years.

2) Senior citizens who have no other sources of income.

Debt funds on the other hand may be better if you would like to park the funds for eventual exposure to equity through MFs.

“With the tax arbitrage on debt funds being done away with recently, they are no longer as lucrative compared to fixed deposits as they used to be. The additional risks associated with debt funds may not be worth the incremental 50-100 bps annual return that they could potentially deliver, especially when you consider that the risks themselves are complex and beyond the understanding of most retail investors. Since both debt funds and fixed deposits are suitable for short term goals, actual effect of any potentially higher return would be limited due to the limited impact of compounding in this scenario,” said Mayank Bhatnagar, Chief Operating Officer, FinEdge.

Also worth considering is the fact that debt funds may be forced to take on additional credit risks now, to deliver FD+ returns and remain relevant. “The days of sticking to the safety and comfort of G-Sec and AAA may be over. This calls for an additional layer of caution from investors, and it is advisable to consult an advisor and evaluate portfolio risks carefully before investing into debt funds going forward,” cautioned Bhatnagar.

At this juncture, low risk-taking investors could also consider corporate FDs that are rated AA+ or above. Many of these instruments carry low credit risk, and are offering 250-300 bps higher interest rates than most bank FD’s.

According to CA Ruchika Bhagat, MD, Neeraj Bhagat & Co, choosing between fixed deposits and debt funds depends on various factors, including your financial goals, risk tolerance, investment horizon, and recent changes in taxation.

Here are the factors to consider: 

1. Risk and Return: Fixed deposits are relatively low-risk with fixed returns, while debt funds have varying risks and returns depending on the underlying securities. Assess your risk appetite and return expectations.

2. Liquidity: Fixed deposits typically have a fixed tenure, and premature withdrawals may result in penalties. Debt funds offer better liquidity, allowing you to redeem your investment partially or completely as needed.

3. Tax Efficiency: While fixed deposits have taxable interest, debt funds provide indexation benefits for long-term capital gains, reducing tax liability. Consider your tax bracket and the impact of recent changes in taxation on both options.

4. Investment Horizon: Determine your investment horizon. Fixed deposits are suitable for short-term goals, while debt funds offer flexibility for medium to long-term investment objectives.

5. Diversification: Debt funds provide diversification by investing in various fixed-income instruments. Fixed deposits, on the other hand, are concentrated in a single institution. Diversification can help reduce risk.

6. Inflation Adjustments: Consider the impact of inflation on your investment returns. Debt funds with indexation benefits may provide better protection against inflation.

7. Post-tax Return: Options that give hire post return is always a better option.