Most Short duration and Liquid Funds are marketed as instruments which provide higher liquidity than FD and slightly higher yield.
This is a myth because:
- Short term (below <3 year) Debt funds are taxed at your tax slab which means it could be as high as 30%.
- No matter how safe a debt fund claim to be they invest in corporate credit and they are susceptible to default. The slight excess return are not worth the risk.
- Debt Funds with higher duration have high interest rate risk and for a non professional taking an interest rate direction call is not easy.
Long Duration Funds suffer from Interest Rate Risk!
If someone does not have immediate liquidity requirement they can optimise Fixed Deposit to get high yield at very low Risk!!
They can effectively Create a risk free portfolio delivering 8.5%
How to go about doing that!
Three major Pain Points of Fixed Deposit:
- Taxed at Marginal Rate
- Low Interest Rate
- FD carry a credit Risk too if a bank defaults.
How to by pass these pain points:
We can use this tax guideline for our benefit to address first two points:
As per the current laws, any gift received in cash or kind exceeding Rs 50,000 is taxed in the hands of the recipient as “income from other sources”. However, this rule does not apply to gifts received from relatives. Additionally, any gift received on the occasion of your marriage, under a will or inheritance is not taxed in your hands.
Let’s assume that your parents are senior citizens (above 60) and have no income. You can gift them any amount of cash for investing in high-return instruments such as senior citizen’s savings scheme.
As senior citizens do not have to pay any tax for annual income up to Rs 2.5 lakh, the interest income does not become taxable unless it exceeds this exemption limit. This means you can invest up to Rs 25 lakh through each of your senior parents without any source of income if the annual interest or return is 10%. You can invest up to Rs 50 lakh through your senior parents and have a tax-free annual income of Rs 5 lakh.
Most FD provide additional interest rate to senior citizens plus there is no tax liability.This will ensure high returns and zero tax.
Now how to address the risk of default by bank.!
Another RBI notice will help us to tackle this problem.
1. Bank Deposit Insurance is covered by Deposit Insurance and Credit Guarantee Corporation (DICGC) which is subsidiary of RBI.
2. The maximum deposit insurance cover is for Rs 1 lakh per customer per bank.
The insurance is based on “same right and same capacity” as on the date of bank default.
As stated above all deposits i.e. savings, current, FD, RD, etc. across various branches of the bank, held by you in your individual name, would be treated as in “same right and same capacity” and considered as one total amount for insurance purposes.
But would be treated as held in “different right and different capacity” in following cases:
- Account held in the capacity of a partner of the firm
- As a guardian of a minor
- As a director of a company
- As a Trustee
- As a Joint Account
And so each of them would be separately insured as shown in the example below
What does it entail??
If you hold joint account, the sequence of name is considered as different entity. So if you have two joint accounts with your spouse where in one case you are first holder and in second case your spouse is the first holder, both accounts would be considered as 2 entities and separate deposit insurance would apply.
So if both your parents are senior Citizen (A and B) and you are X,you can save in FD:
- A : 1 lakh
- B: 1 lakh
- joint account A& B : 1 Lakh
- joint Account B&A : 1 Lakh
You can also have a joint account with you as second holder with them and further deploy more money!
You can open such FD in other banks and repeat the process.
Its quite Interesting the Risk Free Rate for 3 years is close to 6.5% in goverment bonds which have a interest rate risk due to the tenor but by using this method to invest you have made your Risk Free Rate as 8.5% (IDFC, RBL,IndusInd provide 8.5% approx for senior citizen FD)
We have effectively made our Risk Free Rate 8.5 % FROM 6.5%
RBI circular on Insurance
2 thoughts on “Create a Risk Free Fixed Deposit Portfolio”
Thanks Rohan for yet another insightful post.
Senior Citizens Saving Scheme is a very useful investment option quite often ignored by many. The banks do not promote SCSS as they are cannot get commissions like regular mutual funds.
I wish you have given more details on the SCSS such as the
1. five year lock-in period
2. quarterly interest accruals
3. no reinvestment on the interest accrued.
4. maximum 15lakhs investment limit per person
Keep updating your useful blogposts.
Thanks for your feedback. I would update the post with your points!