Monday, 13 June 2016

Understanding Fixed Maturity Plan (FMP) , Taxation and Benefits

Fixed Maturity Plan : Your Friendly Alternate to Traditional Investment


Most of us like traditional investments mainly for two reasons:
  • It offers assured returns 
  • It has a date of maturity
You are comfortable at knowing the value of your savings at maturity accordingly you can plan for your expenses or may be other investments better

What if you have an investment solution that seeks to provide :
  • a specific maturity date 
  • an exposure to high quality bonds 
  • risk adjusted returns along with tax benefit 

 

What is Fixed Maturity Plan : 


Fixed Maturity Plan matures at a pre specified period and it generally invest in fixed income securities like Non-Convertible Debentures(NCDs), Corporate/Government Bonds, Treasury Bills (T-bills), Commercial Papers(CPs), Certificates of Deposit (CDs), Bank FDs and other money market instruments. 
FMP are closed ended mutual fund scheme. FMP invests only in instruments whose duration is similar to its own term i.e., it aligns its term with that of its underlying assets. For example, recent NFO of ICICI Prudential Fixed Maturity Plan - Series 79 - 1126 Days - Plan C will invest in instruments that mature for 1126 days or before that. 

Why a Fixed Maturity Plan?

 

  • Fixed Maturity Plans aim is to offer risk adjusted returns along with tax benefits.
  • Currently debt security yields are at elevated levels in the 1-3 year space. It could be a good time to lock into high yield debt issuance of various issuers and hold them till maturity to benefit from the prevailing high interest rates.
  • While investing in such securities, there is an endeavor to align their maturity with that of the plan to manage the interest rate risk. For instance, an FMP of a three-year maturity will invest only in securities that mature on or before three years.
  • Because of the size, the fund might invest in securities which are usually not available to retail investors. These securities might offer various benefits such as better credit quality.
  • Moreover, the returns from FMP have a tax advantage. This may vary from investor to investor and is subject to taxation laws. This tax advantage makes FMP an efficient investment choice

Tax Advantages of FMP vs Bank Fixed Deposits


FMP has an advantage when compared to similar investments like Fixed Deposits (FDs). In FDs, Interest earned is added to your income and taxed at your income tax rate. Interest from FD is categorized as "Income from other sources" as per the Income Tax Laws.  In the case of FMP, tax implication depends on the investment option chosen Dividend or Growth

Which option to choose ?


Dividend  Option : Dividends  in  FMPs  are  tax  free  in  hands  of  investors but Mutual  Fund companies  have  to  pay  a 28.33% Dividend  Distribution  Tax  (DDT)  including surcharge and cess and  30%  plus  surcharge  and  cess  for  others  (33.99%)  before distributing it to you as investors

Growth Option: If you opt for Growth option, it is subject to Capital Gains Tax. Short Term Capital Gains (if units are held for 36 months or less)  are taxed as per the Income Tax Slab Rate of investors. For Long Term Capital Gains (if units are held for more than 36 months) are taxed at 10% without indexation or 20% with indexation. The indexation benefit inflates the cost of purchase lowering long term gains tax liability, which is not the case of FD.

The tenure of the holding period matters, when one has to decide between growth and dividend options. You can go for the growth option if the holding period is more than a 3 years and for the dividend option if the holding period is less than 1 year


The reason is that gains from investment in Mutual Funds, if redeemed after 3 year in debt schemes, are considered
long-term capital gains. In the case of long-term capital gain, the investor is given the option of choosing between

  • 20% tax rate with indexation benefit, and 
  • 10% tax rate without the benefit of indexation
Before discussing the benefits of indexation, let’s first understand the concept. Normally, for calculating capital gains, we reduce the cost from the sale value. For calculating long-term capital gains, the amount invested is multiplied by the inflation multiple (Inflation Index for Redemption Year/Inflation Index for Investment Year) and then this indexed cost is subtracted from the amount realized at redemption. The extent of capital gains gets reduced,and so does the tax liability.
Below table illustrates the returns of Fixed Deposit vs Fixed Maturity Plan

Details Fixed Deposit FMP
Amount Invested (A)100000100000
Month & Investment Year Feb-12Feb-12
Rate of Return 9.50%9.50%
Holding Period36 Months36 Months
Month & Redemption Year Feb-15Feb-15
Amount at Maturity 131293131293
Gain 3129331293
Index Cost NA130446
Capital Gain 31293847
Tax Rate 30.90%20.60%
Tax Payable 9670175
Post Tax return2162331118

In our example above Cost Inflation Index (CII) for year of redemption (2014-15) is 1024 and year of purcahse (2011-12) is 785. The indexed cost of purchase = (A*1024/785)
 

Highest bracket of tax rate has been taken based on current IT slabs.

It is difficult to redeem Fixed Maturity Plans before the maturity or final date of redemption. Investors looking for redemption before maturity have to sell the units on the stock exchange. As per guidelines, all FMP schemes are listed on the stock exchanges however; trading is rarely done on the units.


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