Are we actually creating wealth with our Fixed Deposits?
Without much ado lets understand this calculation with the help of an example.
Mr. Ramesh has a fixed deposit with a bank and earns interest at the rate of 8% per year. He has a annual income of Rs 12,00,000 (Income Tax bracket of 30%). What is the Real rate of return he will earn? It’s of course not 8%. Let’s find out.
FD Interest rate is 8%
Mr. Ramesh falls in 30% tax bracket, so 30% of the 8% interest he earns will be paid as tax – 10% will be deducted at source (TDS) and the remaining 20% during filing of IT return. So, effective return he earns now is 8- (30% of 8) = 8 – 2.4 = 5.6% and this is not all.
Now, consider inflation. Considering a base inflation of 5%, effective interest now will be 5.6 – 5 =0.6%
This 0.6% interest, called the Post Tax Inflation Adjusted Return,is what Mr. Ramesh is earning and adding to his wealth. If, actual FD rate of interest is considered and the actual average inflation is considered (which is generally considered in such calculations and includes inflation on lifestyle commodities) matter may go worse and Mr. Ramesh might end up getting a negative return i.e he might be actually eroding his wealth by investing in a FD.
But, FDs can still be a better choice of investment instrument depending on the Risk appetite of the investor, the investment time horizon and the goal of the investment.