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Fixed Income

Liquid Funds are better than Fixed Deposits

The increase in Dividend Distribution Tax (DDT) in Budget 2006 has been touted as a big issue. Specifically on liquid funds and money market instruments, where the Finance minister increased DDT to 25%, to “plug an arbitrage” between them and bank fixed deposits. The thing was – DDT for liquid funds was 12%, so obviously people chose that over a fixed deposit where you would pay tax on all income at your marginal tax rate. So the increase to 25% would make bank deposits more attractive.

Meaning, if you earn more than 2.5 lakhs a year, you would pay 30% (+3% cess = totally 30.9%) on income from a fixed deposit. Liquid funds which usually pay out dividend often (weekly, daily) now have to pay 25% on the amount they distribute, plus 10% cess and 3% education cess (28.325% in total).

But I maintain that even with this, you pay far lesser for a liquid fund than you do for fixed deposits, if you make more than 2.5 lakhs a year. Here’s how.

Let’s assume that you invest Rs. 10,000 in either avenue. And let us say both earn the same return – 10% per year.

In an FD, you will get Rs. 1000 as interest. And you have to pay 30.9% of this as income tax – that’s Rs. 309 gone – and you’re left with Rs. 691. That’s an effective return of 6.91% for the fixed deposit.

Now let’s say a liquid fund (which you bought 1000 units at Rs. 10 NAV) earned Rs. 1000, which means the NAV stands at Rs. 11 today. Now the liquid fund wants to pay out Rs. 1000 as dividend. Does it declare Rs. 1000 as dividend and pay 28.325% dividend tax? No!

The NAV will drop down after paying dividend. How much is required so that the NAV comes down back to Rs. 10 (so that your “principal” is maintained)? They will declare Rs. 7.79 as dividend per unit. The DDT for this is Rs. 2.21 which they pay the government.

Let’s see how much you make, for your 1000 units. You get Rs. 779 as dividend, which means a net yield of 7.79% for a liquid fund.

The tax advantage is obvious: At 10% gross return, you pay Rs. 30.9% tax for a fixed deposit and only 22.1% tax for a liquid fund.

And another benefit is penalties – if you pre-close an FD, you will lose some of the interest because they will give you a lower rate for the period you used. Liquid funds have no such penalties and you get the full interest for all the money you use.

Note though, that liquid funds have varying yields based on the rate of interest currently in the market. FDs freeze the interest rate. Therefore, in a regime where interest rates are coming down, it is perhaps better to use an FD to lock in a higher interest. But at this point the interest rates are going up, and liquid funds are a better alternative there too – as the increase in rate will immediately reflect on your return.

The only advantage of FDs is the fact that you get money post DDT. So for the example you see only Rs. 779. Banks only deduct 10.3% TDS, so you would see Rs. 897. But of course you’d have to pay tax later anyhow.

Why would you choose a fixed deposit in this scenario? One reason can be that liquid funds don’t want investments less than Rs. 50,000. But that’s just the first entry, subsequent purchases can be of much lesser, Rs. 10,000 or so. If you can gather the initial Rs. 50,000 – even temporarily borrowed – you can stay in and get a better return.

For corporates this is even better – they pay 33.99% tax on other income, but dividends are tax free. Liquid funds which effectively have lower tax still outperform bank fixed deposits. So much for plugging the arbitrage!

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