Fixed Maturity Plans are being touted as the new way to lock yourself into about 10% yields. But Sandeep Shanbhag mentions why the Direct Tax Code screws the FMP buyer.
FMPs are locked in for a period, the biggest that are being sold now are 370 days or so. That is, you get in now, you get out a year later. Since no one else can get in meanwhile, the fund buys 1 year securities (currently at around 10%) and locks in the interest.
Why is this better than a fixed deposit? FD income is taxed as part of your other income, which could be 30% at the highest slab. FMPs, when held for a year, attract both indexation and Long Term Capital Gains Tax. (Read my post on how LTCG is calculated).
If inflation is 7% and you get a 10% return, your net taxable portion is just 3%, on which 20% is the tax, so you pay just 0.6% of your principal as tax, for a net return of 9.4%. (10% minus 0.6%)
Not any more. The DTC says that for long term capital gains to apply you have to hold for one year after the END of the financial year of investment. Meaning, if you buy today (August 1, 2011), you have to hold the investment till April 1, 2013. (Financial years end on March 31)
Secondly, there’s no “20%” tax – the special rate for LTCG expires with the DTC. All long term non-equity gains, post indexation, are added to income.
1 year FMPs will mature after a year; with the new rule, the investment won’t qualify under long term holdings. Short term gains cannot be indexed, and are directly added to income. For a one year FMP, you’ll earn 10% and all of it will be taxed, which at the highest slab is a tax rate of 30%. You’ll earn a net of 7% – exactly the same as a Fixed Deposit.
Equities on the other hand have zero long term cap gains taxes, and the holding period for qualification is one year from the date of investment (not from the end of the financial year like above). Short term gains have better treatment – only half the gains are added to your income.
If you’re looking to buy, only consider FMPs that are 20 months or more.