Best time to invest in Fixed Maturity Plan is approaching – Are you ready to take its advantage?

Generally as a principle this blog do not advise its readers to make investment decisions primarily based on tax angle.  Investment and tax both are separate.  However, one should always ensure that after a nature of investment is selected, the type of investment chosen is most tax efficient.  Here Fixed Maturity Plans (FMPs) comes in to picture.  They are suitable for investors looking for low risk investment for a short investment horizon of up to 15 months.  They are tax efficient as against the traditional fixed deposits.   

The months of February and March are the best to take the most out of this tax benefits.  Before we discuss about the tax efficiency of FMPs, let us understand more about them.

Structure of FMPs

FMPs are close-ended income scheme of mutual fund companies that tries to generate income through investment in debt, money market instruments and government securities.  They basically invest in corporate bonds, commercial papers, certificate of deposits and similar securities and sometimes in government securities and fixed deposits.  They are issued for specific tenure which varies from 15 days to 90 days, 370 days or 500 days.  As the tenure is known, it is possible to estimate the indicative returns these funds will generate during the investment horizon. 

They are not absolutely safe investment options and have a probability of default and credit risk since they invest in companies and there is a probability of a particular company defaulting in payment.  To compensate for this risk, they offer slightly higher returns than safer fixed deposits.  However, as in the case of fixed deposits, one cannot be sure of exact returns he will earn at the time of investment. 

Being closed ended, investment in FMPs is possible only during the offer period.  However nowadays many of them are listed on the stock exchange and can be bought & sold.  But the volumes are negligible and the returns may not be optimum in such cases.  FMPs are not much advertised and primarily are meant for institutional and corporate investors, however, retail investors can also invest.

One should ensure that FMPs should be from a reputed fund house which invests in good corporate papers.  In 2008, many FMPs invested in real estate companies and faced problems when downturn started.  Hence one should check on fund house before selecting their FMP.

Taxation angle of FMPs

FMPs, being mutual fund units, have same tax structure as other debt oriented mutual fund units.  If they are sold within a year of purchase, short term capital gains tax will be charged based on existing tax slab of the investor.  However, if they are sold after one year, it will be treated as long term capital gains and the tax rate will be 10% without indexation benefit or 20% with indexation benefits.  Indexation is basically a system which allows the investor to adjust its purchase price based on cost inflation index.

How do they score over Fixed Deposits?

The advantage of FMPs is more noticeable if we take tax aspect into consideration.  In case of FMPs for more than one year tenure, one needs to pay tax @ 10% or 20% depending on whether one chooses to have indexation.  Whereas, irrespective of the tenure of fixed deposits, the interest is treated as income from other sources and normal tax slabs applies.  Thus in case the investor is in 30% tax slab, he will be required to pay tax @ 30% on the interest generated.  Thus FMPs are more advantageous for investors in 30% tax slab looking for an investment with an horizon for more than one year.

FMPs are available in dividend and growth options.  The dividend distribution tax is 16.61%.  Hence for FMP investments with less than 1 year tenure, it makes sense to opt for dividend option, since part of the income can be distributed as dividend on which 16.61% tax will be paid by the fund house and there will not be any further tax liability on investor.

February and March – the best period to invest

Due to the indexation benefits which are available, it becomes more beneficial to invest during certain months of the year.  Suppose for example, if you make investment in 370 days FMP on 29^th March 2011,  it will mature after 370 days on 2^nd April 2012.  However, for the income tax purpose you have made the investment in Financial Year 2010-11 and sold the investment in Financial Year 2012-13.  Thus you reap the benefit of indexation for two years i.e. FY 2011-12 and FY 2012-13 and your tax outgo accordingly reduces.  The same applies if someone invests in FMPs for 400 days in end of February.  Hence it always makes sense to invest in FMPs during the concluding months of financial year.

Summarizing the above,

a.      For a person in 30% tax slab, it makes sense to invest in FMPs instead of fixed deposit (for more than one year investment horizon).

b.     It makes more sense to invest in the concluding months of the financial year to take the advantage of double indexation benefits.

c.      For investment horizon less than 1 year, tax impact on the gain is same for both fixed deposits and FMPs.  However, since dividends distributed by FMPs are taxed @ 16.61% , it may be wise to choose dividend option for FMPs less than 1 year.

Where you aware about these advantages of FMPs?  Do share your comments below.

Update on this article was posted on 22nd February 2011.  Link