Save Smart. Improve FD returns with tax deferral

Interest rates on fixed-income investments such as bank deposits have fallen sharply over the past year, and most banks now offer just 5.5–6.5 per cent across various tenures. 

Add to this the tax burden on the interest, the post-tax return comes down to a low single-digit for many. 

Is there a way to optimise returns in this situation?

Tax deferral can help. Tax deferral essentially means that you postpone paying taxes – that is, you pay taxes on your interest income not immediately, but on a future date. 

This is possible on cumulative deposits (in which interest accumulates each year and is paid out at maturity). 

You can opt to pay tax on the accumulated interest at maturity, and not on the interest earned every year.

See the example in the accompanying table.

The investment of ₹1 lakh in a three-year cumulative fixed deposit at 6 per cent per annum on an annual compounding basis gives a higher return (₹235) when the tax is deferred to maturity than when it is paid on on an annual basis. In short, deferring the tax payment to a future date enhances your return on investment.Don’t brush aside the benefit as a small gain. The extra earnings can be large with an increase in the investment size and the tenure. In any case, to a prudent investor, every rupee matters.

  Here' how

Tax deferral enhances investment returns because it allows a larger amount to compound until maturity. 

When you pay tax every year, the money paid as tax loses the benefit of compounding. 

So, in the above example, the ₹1,800 you paid as tax in the first year didn’t get compounded for the next two years, and the ₹ 1,876 you paid as tax in the second year didn’t get compounded in the third year.When you defer the tax payment, along with the original investment, the entire interest earned also gets the full benefit of compounding.

It’s allowed

An investor can declare interest income on receipt at maturity, or on an accrual basis, annually. 

That is, the taxpayer has the choice between the cash and the accrual/mercantile basis for declaring such income to tax.

Suresh Surana, founder, RSM India, explains: “The interest earned from bank fixed deposits or company fixed deposits is taxable in the hands of the taxpayer. The taxation of such interest amount in the hands of the recipient would depend on the method of accounting followed by him/her. If the recipient follows the mercantile method of accounting, the interest should be offered for taxation on an accrual basis, or otherwise on a receipt basis, if the cash system is being followed. Thus, the taxpayer has an option to tax interest on an accrual or a receipt basis depending on the system of accounting followed.”

The choice between accrual and cash basis has to be applied consistently, though. Flip-flops may be questioned by the taxman.

TeDiouS hitch

But there can be a fly in the ointment. This is due to the tax deducted at source (TDS) that banks and companies have to cut while paying or crediting interest above specified thresholds. The interest may not be paid out but can still be subject to TDS. 

Surana says: “As per Section 194A of the Income Tax Act, the tax deductor has to deduct the TDS at the time of payment or credit to the account of the payee, whichever is earlier, ie, accrual or receipt, whichever is earlier.”

The implication is that even if you follow the cash basis and want to account the interest income only at maturity, the bank/company would still cut TDS if the interest income in a year crosses a threshold.

Shailesh Kumar, Partner, Nangia & Co LLP, says: “For banks, cooperative societies carrying on banking business and post offices, the requirement to deduct TDS on interest arises if the aggregate interest during the financial year exceeds ₹40,000 (this limit is ₹50,000 in case of senior citizens). For companies/other payers, the threshold is ₹5,000, beyond which they are required to deduct TDS. The rate of TDS is generally 10 per cent. But it is 7.5 per cent from mid-May 2020 until March 2021 due to the coronavirus-related relaxation.”

Once the TDS has been cut by the bank/company, it will reflect in the form 26AS, and the taxpayer would have to pay the balance tax in the year. 

Alternatively, the taxpayer has the option to carry-forward the TDS credit to subsequent years in which the income would be offered to tax on a receipt basis. But there could sometimes be practical difficulties in such carry-forward of TDS credit from past years, says Kumar. Also, the TDS already cuts the compounding benefit anyway. 

The solution  

The solution — if you want to follow the receipt basis — is to plan your investments such that there is no annual TDS on the interest income from cumulative deposits. You can do this by spreading your deposits across banks such that the total annual interest income accrual from each bank does not exceed the threshold — ₹40,000 for individual taxpayers and ₹50,000 for senior citizens. 

Depending on the prevailing rate of interest and the investment tenure, the deposit amount will vary. 

For instance, in a cumulative bank FD for three years at 6.5 per cent per annum, an investment of up to ₹5 lakh should keep the annual interest comfortably under the TDS threshold.

Possible complication

Be careful. This tax-deferral approach could backfire if it results in your moving into a higher tax slab, say, from 20 per cent to 30 per cent, due to accumulated higher interest income in the year of receipt. 

A cost-benefit analysis would then be needed to make a decision — if the additional return from the tax deferral is more than the higher tax due to the slab shift, tax deferral would be worth it, else not.

For those already in the highest tax slab and for those who will not shift to higher tax slabs, tax deferral can be a clear winner.

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