Fixed Maturity Plans offer better returns than Fixed Deposits
FMPs differ significantly from FDs and offer a higher flexibility to investors when it comes to tax on returns. Unlike FDs, wherein the interest income is taxed as per the investor’s tax slab, the tax treatment for FMPs depends upon two options: dividend or growth.
The dividend options of FMP scheme attract 12.96% dividend distribution tax (DDT), which is deducted at the source. Returns from the growth option are subject to capital gains tax, which can be either short term (STCG) or long term (LTCG) depending on the tenure. If an FMP is sold within a year of purchase, STCG tax would be charged based on the existing tax slab for the investor.
For tenure higher than that, LTCG tax depends upon whether the investor opts for indexation or not. LTCG without indexation attracts 10.3% tax whereas it is 20.6% under indexation.
The power of indexation Indexation is a mechanism that allows the investor to adjust the return rate of an FMP-growth instrument for the rate of inflation during the tenure. It is a powerful tool that makes FMPs more lucrative than FDs.
In an economy where inflation grows faster than FMP’s annual rate of return, indexation results into a lower tax outgo even though its stipulated tax rate is twice that of FMP without indexation. Investors can also use the facility of double indexation to reduce the tax impact further.
In cases where FMP tenure exceeds 12 months, double indexation arise, since the rate of inflation is calculated not once a year but over two years, which results into a higher indexation rate in an inflationary economy such as India.
The table offers more clarity on double indexation wherein the rate of inflation is calculated over the two years ending FY11. Also, in case of post indexation long-term capital loss (LTCL), the investor can adjust the loss against LTCG. For example, in the table, the third case shows a post indexation loss of Rs 11,429.
This amount can be adjusted against LTCG from any other investment thereby reducing the overall tax payable.
Fixed maturity plans (FMPs) offer investors the twin benefits of investment and tax savings. Not so popular among investors, FMPs are a fixed tenure, closed-ended mutual fund (MF) scheme with characteristics similar to that of a bank fixed deposit (FD).
Under an FMP, funds are invested at the time of initial offer for a stipulated time and can be redeemed only at the end of the lock-in period. Usually misunderstood to be equitylinked schemes, FMPs are, in fact, pure-play debt funds. Funds under FMPs are invested in debt and moneymarket instruments including corporate bonds, commercial papers and certificates of deposit, etc and in government securities as well.
FMPs are issued with different maturity periods like three or six months or one, two and three years. What makes FMPs different from FDs is the return profile and tax treatment.
FD’s Unlike FDs, returns are not guaranteed under FMPs. FMP offers an indicative return, also known as the indicative yield. It is based on the returns offered by the underlying financial instruments that FMP invests into and tends to vary from the actual returns at the time of maturity.
FMPs are more suitable to investors with higher risk profile. To compensate for the inherent risk, FMPs offer relatively higher returns. Further, even though returns are not fixed, FMPs do offer a greater liquidity to investors as they can trade on exchanges.
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What You Should Do
Investors, who can bear a relatively higher risk, should prefer FMPs to bank FDs. Those looking for a short term investment option should pick FMP-dividend, as it attracts less tax. However, long term investor should ideally go for FMP growth. Further, it attracts the benefit of double indexation for the maturity between 12 months and 24 months, which may reduce the overall tax outgo on investments. Investors, who require assured returns, should, however, opt for FDs.