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Saturday, February 25, 2012

Fixed Deposit - How Taxation can affect your Returns?

Equity markets have been highly volatile during the last few years. Still recovering from the last fall, coupled with steep rise in interest rates, most of the investors have since looked for safer avenues to safeguard their investments. Although, among all debt instruments, Public Provident Fund(PPF) , National Savings Certificate (NSC), Post Office Monthly Income Schemes (POMIS)  always command high priority, Fixed Deposits(FDs) by banks have gained popularity in recent times. The primary reason is the attractive interest rates offered by the banks along with sovereign guarantee, giving investors a sense of security.
However, within this euphoria, most investors neglect taxation aspect while investing in fixed deposits. What they failed to consider is that taxation can significantly lower returns generated by this instrument.
How FD is taxed
The interest income earned through fixed deposit is taxable, if the interest amount exceeds Rs 10,000, in any financial year. This income is added to your total income under header "Income from other sources" and then taxed as per the income slab. A very important point to note is that the interest income from fixed deposits are taxed on accrual basis and not when actually received. This means that the tax on interest income earned at the end of financial year have to be paid even if the interest is credited at a later year. For e.g. if you are investing Rs 75000 in a  fixed deposit for five years, you will have to pay tax on liable interest for all financial years it spans, even though the interest will be credited at the end of fifth year. Also, Tax Deducted at Source (TDS) is deducted by the banks if the interest amount exceeds Rs 10000 from one or through multiple investments. Even FDs in name of the minor attract TDS, if the interest exceeds the limit.
What you earn?
In a higher interest rate scenario, the going is good for investors in lower tax bracket. The investments from fixed deposits yield them returns that are worth talking about. But as your income go into the higher slabs the taxation starts affecting the net earnings.
Consider an interest rate of 9.25% p.a. on a 10 year fixed deposit of Rs 2 lakh. Most of us will be lured by this fixed return which is very high if compared with rates few years back. However, the real picture is very different from what is presumed when taxation is considered.
Tax Slab (%)
Amount  Invested (Rs)
Interest (Rs)
Tax (Rs)
Net Interest Earned (Rs)
Post Tax Return (%)
                  As can be seen from the above illustration individuals in higher tax slab of 30.9% tax, the post-tax returns are 6.3% from this fixed deposit. As against this, an individual in the lowest tax slab will be able to fetch 8.3% return on the same investment post taxation. Surely, the benefit accruing to lower tax category has lot to cheer.
Should you Invest
Fixed Deposits are highly liquid instruments and hence are best suited for goals where immediate fund requirement is very high. However, sometimes, high interest rate scenarios like existing today provides good investment opportunities for some category of investors even for long term. Senior Citizens who earns .25-.50 basis more on FDs and enjoy higher exemption limit in income tax are poised to benefit most from this instrument. A retired banker (Senior Citizen) today is able to fetch interest rate close to 11% on a 10 year FD from the same bank where he served. Even if he pays the maximum marginal tax he will still earn close to 8% which will give him a decent income. Inflation is something one has to live with but effect of taxation can be reduced by deploying some tax planning strategies. What you need to consider is post-tax earnings and not just the attractive interest rates, to get a true picture of what you will receive at the end. 
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