Why stock market index funds are better than fixed deposits for income tax payers.

First let's start with a look at the Fixed deposit (FD) interest rates.

This averages to about 6.5% average return on FD annually.

A similar table for Nifty 50 (a stock market index).

The average annual return for nifty 50 is 12%.

So right away you can see that a stock market index outperforms an FD.

But before we dig deeper, let's clarify some terms:

Fixed deposit:

It is a financial instrument offered by banks and financial institutions where you invest a lump sum amount for a fixed tenure at a predetermined interest rate, earning returns higher than a regular savings account.

In simple words, you give money to the bank, the bank gives you fixed interest payments and the principal back after the tenure.

Stock market index:

A weighted average of a group of stocks representing a specific segment of the market, providing insights into market trends and overall economic health.

As an example an index like Nifty 50 represents the average performance of the top 50 companies listed in the stock exchange of NSE.

Stock market index fund:

A stock market index fund is a mutual fund that mimics the performance of the index by investing in the same stocks and in the same proportions as the underlying index it aims to replicate.

The fund’s goal is to track the returns of the index as closely as possible, offering investors a low-cost and diversified way to gain exposure to the overall market or a specific segment of it.

Now, I try to answer the question on why an index fund is better than an FD from a tax perspective.

Even though the stock market gives you better returns than an FD (12% vs 6%), in order to compare the two,

• Let's assume they both give you the same 10% return.
• The time period of investment is 10 years.
• I start with 1 lakh Rupees as the starting principal.
• The income tax rate that applies to you is 30% (highest tax bracket).
• And the long term capital gains tax is 12.5%.

For Fixed deposits, let's calculate the amount at the end of 10 years based on this formula.

Final Amount = 1,00,000 * (1 + 10/100)^10

However we have to make some adjustment to that 10%, as you will be paying annual tax out of it.

So if you earn Rs 10000 (10% of Rs 1,00,000), the tax will be Rs 3000 (30% of Rs 10,000). So your effective post tax earning will be Rs 7000 (10,000 - 3,000) and your effective return will be 7% (Rs 7000 out of Rs 1,00,000).

This rate will be the same every year assuming the tax bracket you fall under remains the same.

So the amount at the end of 10 years will be 1,00,000 * (1 + 7/100)^10 = Rs 1,96,715

Now let's do the same for the index fund.

The formula is the same, however annual taxes will not apply because you don't pay taxes on stock market returns unless you sell it.

So let's assume you sell it at the end of 10 years period and long term capital gains of 12.5% apply.

Amount before tax = 1,00,000 * (1 + 10/100)^10 = Rs 2,59,374

Amount after tax = 1,00,00 + 1,59,374 * (1 - 12.5/100) = Rs 2,39,452

The effective annual rate of return would be 9.1%

So the amount at end of those 10 years

For FD : Rs 1,96,715

For index fund: Rs 2,39,452

The post tax effective rate of return on FD is 7%, whereas on the index fund is 9.1% even though we start with the gross return as 10%.

This has to do with how taxes apply differently.

So in conclusion,

1. In the past 10 years stocks have given double the returns when compared to FDs.
2. Taxes for stocks have to be paid only when selling the stock, which in case of index funds can be held indefinitely to pay as low a tax as possible. This is in contrast to the FDs for which the taxes have to paid annually.
3. Capital gains tax (12.5%) is much lower than the top income tax rate (30%).