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How do tax saving FDs have such high effective yields of 16.64 % pa?


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A client of mine called me up recently to tell me that her bank was offering an interest rate of more than 16 % pa on tax saving fixed deposits, and for senior citizens, it was even higher! This was informed to her by the customer service staff when she had been to her bank for some routine transactions. She was also given a printed paper/ad which asserted this fact.

 

In an era of stagnant stock markets, high inflation and falling interest rates, this sounds too good to be true, right? Well, you are not entirely wrong! There is a catch. Let me explain this –

 

Tax saving fixed deposits are 5 year deposits offered by banks wherein the invested amount can be claimed for tax rebate u/s 80C. Now, the return specified on the advertisement is not the actual interest rate earned pa, but the effective yield, assuming that you fall in the highest income tax bracket of 30 % and after factoring in the tax rebate. The following table makes this clear –

 

S.No Particulars Tax slab 30 % Tax slab 20 % Tax slab 10 %
1 Amount of Investment 10,000 10,000 10,000
2 Tax Saved 3,090 2,060 1,030
3 Net Investment 6,910 7,940 8,970
4 Maturity Amount * 15,228 15,228 15,228
5 Effective 5 year yield pa 16.64% 13.91% 11.17%

 

* assumed 8.5 % pa interest for a 5 year period

 

With 8 days left for the financial year to end, there are a section of us who haven’t yet invested the maximum Rs 1 Lakh to claim the required tax rebate u/s 80C. Banks use this opportunity to advertise their tax saving deposits in order to boost their deposit base .While they are not mis-selling or presenting wrong facts, such pamphlets cleverly highlight the maximum benefit one can get and very conveniently ignores the fact that the yield specified is a pre-tax yield and tax is payable on the interest earned. Also, it does not talk about these less attractive features or clauses, which one must keep in mind before investing in these.

 

  • The yield of 16.64 % pa is applicable only to those in the highest tax bracket of 30 %, as can be seen from the table. For those in the lower bracket, it is lower.
  • Only the principal amount invested up to the limit of Rs 1 Lakh gets tax rebate. The interest earned is fully taxable.
  • There is a mandatory lock-in period of 5 years. No premature withdrawals or loans are available during this period.
  • The bank may have other fixed deposits, without the tax rebate and lock-in of similar duration where they offer a higher rate of interest.
  • If the investment is made in joint names, only the first holder can claim tax rebate.

 

Personally, I feel it is a good option for people with a shorter investment horizon wanting to save taxes; those who can afford to invest for a longer duration should consider the PPF or VPF, where the interest earned is also tax free and hence the effective post tax yield is higher.

 

 

 

 

 

 

 

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