Why invest in Fixed maturity plans ?

Interest rates in India have been increasing over the last couple of years. This is good news for those breed of investors who invest in bank deposits and fixed income instruments as the interest rates have increased. Today many of the banks offer 9.5% to 10% p.a. returns over the next 3-4 years.

However, should one blindly go ahead and invest in the bank deposits right away ?. Please remember that as per Income Tax rules in India, interest earned from bank deposits are subject to income tax depending on the tax bracket that the individual is in. There are a number of indiviuals who open deposits in their wife's name thinking that these will be tax free. However, even these are expected to be combined into the income of the husband and tax has to be paid tax depending on the tax bracket that the individual is in.

Thus if the individual was in the highest income tax bracket, one would end paying more than 30% of the interest income as income tax thus reducing the effecting return to between 6.5% and 7% p.a.

This is where fixed maturity plans come in and are different from the fixed deposits.

What are fixed maturity plans?
FMPs, as they are popularly known, are the equivalent of a fixed deposit in a bank, with a caveat. The maturity amount of a fixed deposit in a bank is 'guaranteed', but only 'indicated' in the FMP of a mutual fund. The regulator does not allow fund companies to guarantee returns, and hence the 'indicated returns' in FMPs.

FMPs are debt schemes, where the corpus is invested in fixed-income securities for the tenure of the scheme. The tenure can be of different maturities, from one month to three years. These are typically close ended schemes.

The prevalent yield (equivanent rate that the money will fetch as a return for a given tenure from a AAA rated company) minus the expense ratiowill be the indicative return which can be expected from the FMP.

The reason that FMPs are more attractive is because they are more tax efficient. FMPs are classified under the debt scheme category and enjoy certain tax benefits, such as:
Dividend in the hands of the investor is tax-free. But the mutual fund has to deduct a dividend distribution tax of 14.025 per cent in the case of individuals and Hindu Undivided Families (HUFs), and 22.44 per cent in the case of corporates.

Long-term capital gains (investment of more than a year) enjoy indexation benefit.

Short-term capital gains are added to the income of the investor and taxed as per one's slab, whereas the interest on a bank deposit is added to the income of the investor and taxed as per one's slab.

Let us take an example of a 30 month FMP which, if launched now, will mature in June 2010. It will pass through three financial years. Thus, it can have a benefit of triple-cost indexation for the purpose of calculating post-tax yield.

Bank Fixed With Indexation Without Indexation
Deposit
Amount of Investment (Rs.) 10000 10000 10000
Post Expenses Yield (p.a)* 8.3% 8.30% 8.30%
Tenor (in months) 30 30 30
Approx Maturity Amt 12,075 12,075 12,075
Gain 2075 2075 2075
Indexed Cost NA 11,406 NIL
Indexed Gain NA 669 NA
Tax Rate 33.66% 22.44% 11.22%
Tax 698 150 232
Post Tax Gain 1377 1925 1843
Approx Post Tax p.a. 5.5% 7.7% 7.3%


Thus it is fairly clear that FMPs are more tax efficient than an equivalent Fixed deposit for a given period of time.