The ongoing Covid-19 crisis is forcing people to make some tough economic choices. In a series of three articles, we’ll look at three such choices you may have to make. In the last article, we looked at how to choose between continuing your SIP or paying your loan EMIs during the ongoing moratorium. Here’s the second tough choice: if you have to choose between continuing your mutual funds or move your life savings to the bank, what should you choose?
The answer depends on whether you prefer lower risk with lower returns, or can bear higher risk for higher returns.
Bank ﬁxed deposits or high-yield savings accounts carry very low risk as no one has lost their deposits with a commercial bank in decades. These currently return 4-6% per annum across diﬀerent large banks for the average saver who is not a senior citizen. However, interest income from ﬁxed deposits is fully taxable as per your marginal slab rate. If your tax slab is 30%, your FD returns will be taxed to that extent, unless you’re a senior citizen eligible for certain income tax beneﬁts on this front. Eﬀectively, for a non-senior citizen, a 6% FD will return 4.2% after income tax and that is your eﬀective post-tax return (refer to Table 2).
If you can bear a little more risk for higher income and lower income tax liability, you can consider liquid mutual funds. Liquid mutual funds invest in high-quality debt and money market securities that mature in 90 days or less and hence considered low-risk. Over the last one year, the liquid fund returns were 5-6%. They had been higher in prior periods, but this answer will consider the last one-year returns. The returns are similar to ﬁxed deposits and high yield savings accounts returns. Liquid funds return approximately 1.3% higher per annum post tax than ﬁxed deposits and high-yielding savings accounts because of their higher tax eﬃciency when held for at least three years.
However, all debt-based mutual funds carry a certain degree of risk. Of course, you can make higher returns than in liquid mutual funds by assuming higher risk with ultra-short-term debt mutual fund, short-term debt mutual fund, and other debt mutual funds.
KNOW YOUR LIQUIDATION COSTS & TAX LIABILITIES
Due to the ongoing Covid-19 pandemic, you may be evaluating switching from one instrument to another. For example, you may want to liquidate your debt funds and park the money in bank deposits. In such a situation, be aware of liquidation costs and applicable taxes, and we hope to help you understand this tough choice.
For example, to liquidate your mutual fund units bought in the last 12 months, you might, for example, have to pay an exit load of 1%, for which you need to check your particular scheme documents. Similarly, to prematurely liquidate a bank FD, you may have to take a 1% hit on your interest rate.
While liquidation costs are easy to calculate, your taxes may not be. You must consider the holding period of the asset you’re liquidating to ascertain if it’s a short-term asset or a long-term one. Then, calculate the applicable taxes due to the taxman. You may ﬁnd, for instance, that liquidating your debt mutual fund units held for under three years attract higher taxes than those held for more than three years (refer to Table 2).
You should take time to calculate basis your particular situation including your asset type and tax bracket. Table 1 shows that if you liquidate your liquid mutual fund investment returning 6% a year in two years and move the post-tax proceeds to an FD returning 6% for one year, you will earn approximately 3.9% less on your capital over the full three years. That means you are earning 1.3% less per annum by switching, in this example from a liquid mutual fund to a ﬁxed deposit even without any exit load. However, with a bank deposit you might get peace of mind about capital protection with lower return, which might be the right choice for you. This is your tough choice to make.
WITH EQUITY, THINK LONG TERM
However, with a higher risk appetite and a long-term horizon, you could retain or shift your savings to equity index mutual fund investments. If you’re prepared to wait for ﬁve years from now, you can invest in equity index mutual funds because over the long-term, these have always outperformed post-tax returns from ﬁxed deposits. The key is time.
If you need money in a year or two, you should not be invested in equity mutual funds to start with and should immediately move to a liquid mutual fund or a bank ﬁxed deposit or high yield savings account to protect your life savings and minimize risk. However, if your investment horizon is longer than ﬁve years, you might be better oﬀ in an index mutual funds versus a ﬁxed deposit. As always you should ponder and make the right choice basis your circumstances.
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