How can FMPs save you tax?

Debt funds are simply those that invest in debt securities - like Govt securities, corporate bonds, corporate rated deposits etc. Fixed Maturity Plans (FMPs) are debt funds that have a fixed term - usually 3 to 6 months, and are closed ended, meaning you can only buy in an NFO, not after that.

Many govt securities are 16-20 years to maturity, and to avoid liquidity issues, these and most others are traded in the debt market.

Debt funds are affected by interest rate risk - when the interest rate goes up, the prices of their current securities go down. After all why would you buy an 8% bond for the same value if you have a 9% bond available. So NAVs can flutter around.

FMP Returns are not guaranteed, but usually indicative returns are reached. Why? Because they buy products at the same maturity level, and hold till maturity. So an FMP now may say indicative returns are 9.5% for a 370 day period, which involves them buying securities yielding 10.5% for the period, and holding till maturity. They charge you about 1% as management fees, so the return to you is 9.5%, pre tax.

(If you're thinking - heck, forget them, I'll invest in the instruments myself, banish the thought. The minimum investment can be in lakhs and crores, and some are only available to corporates.)

Even if the interest rate goes up or down it doesn't change the yield for them (since they don't sell or buy the security). How do they give you lesser tax? Two ways.

1. Double indexation. The gains you make are indexed over two years (typical indexation rates are 5% a year) so that you make no gains according to the tax authorities. That involves buying, say, in March of one year and maturing in April of the next year. (Read about indexation)

That gives you two financial years (since years are April-March) of holding, whihc means a typical indexation of 10%+ - so you make 10% or so on interest, and the goverment thinks you made nothing because of two years of inflation, so you pay no (or very little) tax. See for yourself.

2. Lower tax rate: All longer term debt fund dividends are taxed at (about) 19% versus FD interest being at your marginal rate (say 30%). Note: short term debt that involves money market and call money is charged higher dividend rates. Also, capital gains for debt funds held over a year is only 10% (without indexation) or 20% without.

Both these are significantly less taxing than FDs, where the interest is added to your income and taxed at your marginal rate.

What's wrong with FMPs? Well, the interest rate is not fixed. You never know how much you'll eventually get. Second, there is usually some penalty for early liquidation (before maturity) that can actually erode your capital. If they put a 0.25% early exit load, and you want to exit in say a month, the NAV may not have moved enough to cover the exit load itself, so your capital also goes! This doesn't happen with FDs.

Lastly, long term FMPs are not available anytime you want them. Most FMPs open in the Jan-March time frame for the double indexation benefit. In fact March is like FMP paradise. But come April and the drought begins, which makes no sense for someone who has just got some cash in April.

Also read: Rediff's FAQ about FMPs.

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This entry was posted on Tuesday, April 10th, 2007 at 4:49 AM and is filed under Debt, FD, IncomeTax, MutualFunds, TaxSaving. You can subscribe to any comments to this entry via RSS 2.0. You can leave a response, or trackback from your own site.