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Personal Finance

How can FMPs save you tax?

FMPs, or Fixed Maturity Plans are quite in vogue nowadays – and they all tell you they’re going to save you a lot more tax than bank fixed deposits (FDs). How?

Debt funds are simply those that invest in debt securities – like Govt securities, corporate bonds, corporate rated deposits etc. Fixed Maturity Plans (FMPs) are debt funds that have a fixed term – usually 3 to 6 months, and are closed ended, meaning you can only buy in an NFO, not after that.

Many govt securities are 16-20 years to maturity, and to avoid liquidity issues, these and most others are traded in the debt market.

Debt funds are affected by interest rate risk – when the interest rate goes up, the prices of their current securities go down. After all why would you buy an 8% bond for the same value if you have a 9% bond available. So NAVs can flutter around.

FMP Returns are not guaranteed, but usually indicative returns are reached. Why? Because they buy products at the same maturity level, and hold till maturity. So an FMP now may say indicative returns are 9.5% for a 370 day period, which involves them buying securities yielding 10.5% for the period, and holding till maturity. They charge you about 1% as management fees, so the return to you is 9.5%, pre tax.

(If you’re thinking – heck, forget them, I’ll invest in the instruments myself, banish the thought. The minimum investment can be in lakhs and crores, and some are only available to corporates.)

Even if the interest rate goes up or down it doesn’t change the yield for them (since they don’t sell or buy the security). How do they give you lesser tax? Two ways.

1. Double indexation. The gains you make are indexed over two years (typical indexation rates are 5% a year) so that you make no gains according to the tax authorities. That involves buying, say, in March of one year and maturing in April of the next year. (Read about indexation)

That gives you two financial years (since years are April-March) of holding, whihc means a typical indexation of 10%+ – so you make 10% or so on interest, and the goverment thinks you made nothing because of two years of inflation, so you pay no (or very little) tax. See for yourself.

2. Lower tax rate: All longer term debt fund dividends are taxed at (about) 19% versus FD interest being at your marginal rate (say 30%). Note: short term debt that involves money market and call money is charged higher dividend rates. Also, capital gains for debt funds held over a year is only 10% (without indexation) or 20% without.

Both these are significantly less taxing than FDs, where the interest is added to your income and taxed at your marginal rate.

What’s wrong with FMPs? Well, the interest rate is not fixed. You never know how much you’ll eventually get. Second, there is usually some penalty for early liquidation (before maturity) that can actually erode your capital. If they put a 0.25% early exit load, and you want to exit in say a month, the NAV may not have moved enough to cover the exit load itself, so your capital also goes! This doesn’t happen with FDs.

Lastly, long term FMPs are not available anytime you want them. Most FMPs open in the Jan-March time frame for the double indexation benefit. In fact March is like FMP paradise. But come April and the drought begins, which makes no sense for someone who has just got some cash in April.

Also read: Rediff’s FAQ about FMPs.

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  • Anonymous says:

    >Deepak, I have 2 lakh in my s/v acc. I dont it in near future of around 6 to 8 months. I was thinking about FMP, but after reading yout article, i wont go for them. IF I go for liquid funds, then which one should i take? Would you please advice me few names? Thanks, Anoop.

  • Anonymous says:

    >Good posting…….Did you ponder over the issue this budget has brought —two new definitions Money Market Fund and Liquid Fund in the I T Act .Check to see If FMP comes within definition of Market money fund or if it is liquid fund. In both cases , dividend distribution tax is now 100% more .Earlier 12.5 %.

    taxqery…..www.taxworry.com

  • Deepak Shenoy says:

    >Anoop: I think you should go for FMPs if you find good ones. As for liquid funds, I use HDFC Cash Management savings fund to park my extra money when I haven’t got it invested in the markets.

    Anonymous: The tax department hasn’t yet come out with a definition of money market fund – whether it comprises any fund that invests in the money market or only funds that are more than x% or so on. The clarification is awaited.

  • Anonymous says:

    >hi deepak,
    iam a regular reader of ur blog and iam quite new to this investment arena. iam thinking of investing some money in the MFs. I plan to buy Pru ICICI service indus growth fund. Can u please advice me if this is a good decision.
    thanks and regards
    ravi

  • Deepak Shenoy says:

    >Thanks Ravi – I think you need to look at the funds portfolio. It holds Nifty futures as 4.45% of its portfolio – my goodness, why is that? And nearly 13% of assets are in an FD with IDBI.

    They are very big on technology, nealry 26%. You should wait till the results season begins with infy’s results and gauge the situation. Also they have 10% in banks, which may not be a good thing right now.

    Wait till April end. If the outlook for the service sector is good – specifically banks and technology – buy this fund.

  • Cool says:

    >Deepak:

    I am reguler reader of your blog and I find it very informative on investment related issues.
    I wanted to know how can I decide good fmp as almost all fmp indicative returns are same ,It will be great If you can give some more info to help me on this.

    Regards

  • taxquery says:

    >Deepak, here is the definition introduced by Budget 2007 . The excerpt from the notes to the Budget is being given

    “Clause 29 of the Bill seeks to amend the Explanation to
    Chapter XII-E of the Income-tax Act realting to tax on distributed
    income to unit holders.
    It is proposed to insert a new clause (d) in the said Explanation
    so as to define “money market mutual fund” to mean a money
    market mutual fund as defined in sub-clause (p) of clause 2 of
    Securities and Exchange Board of India (Mutual Funds)
    Regulations, 1996. It is also proposed to insert a new clause (e) in
    the said Explanation so as to define “liquid fund” to mean a
    scheme or plan of a mutual fund which is classified by the
    Securities and Exchange Board of India as a liquid fund in
    accordance with the guidelines issued by it in this behalf under the Securities and Exchange ..”

  • Anonymous says:

    >Are FMPs available in May and later part of the year? If yes, do they still offer double indexation benefits?

    Thank you!
    http://www.blogginginvestor.blogspot.com

  • Deepak Shenoy says:

    >Anonymous: FMPs are available all through the year usually. Check this value research page for details on what’s happening in May.

    You can get a one year FMP now but only single indexation benefit.

  • Anonymous says:

    >Thanks, Deepak!

    It seems without double indexation benefit, FMPs and FDs are comparable in return value with pros and cons on both sides. I agree with double indexation FMPs are a better option.

    blogginginvestor