Recurring deposits (RDs) and Systematic Investment Plans (SIPs) are both popular investment options among retail investors to meet financial goals. While one can open RDs with banks, SIP is a mode of investing in mutual funds. Both of them have a major similarity in the sense that these allow investors to invest a pre-determined amount at regular intervals, thereby ensuring regular investment and financial discipline.
However, before committing to either channel of investment, it is important for the investor to understand the returns possible as well as the risk of capital erosion.
Capital protection
RDs opened with the scheduled banks are covered under the Deposit Insurance and Credit Guarantee Corporation, an RBI subsidiary. This insurance programme covers every scheduled bank depositor’s cumulative deposits, including RD, savings, current and FD accounts, of up to ₹5 lakh in the event of bank failure.
Note that insurance covers both interest and principal components. This makes RD one of the safest investment options. For those having deposits in multiple scheduled banks, the ₹5 lakh cover would apply separately to deposits with each banks.
One can use SIPs to invest in equity funds, debt funds, hybrid funds and gold mutual funds. Hence, the scope of capital protection in an SIP would depend on the mutual fund category and sub-category you invest in. Debt funds usually offer higher capital protection than equity funds. Among debt mutual funds, the risk of capital erosion would be lowest and almost negligible in liquid and overnight funds.
Returns expectation
Interest rate applicable at the time of opening an RD stays fixed until its maturity, irrespective of the changes in the RD card rate during the FD tenure. For instance, if one opens the RD of two-year tenure at 6% p.a., the interest rate will stay the same till the end of two years.
This offers a high level of income certainty in RDs, even higher than what many small savings schemes offer. Remember that the interest rates of most small savings schemes are reviewed by the Finance Ministry in every financial quarter.
Returns from SIPs depend on the performance of the selected fund. However, regular and automated investing through SIPs allows rupee cost averaging during market downturns and corrections.
As a predetermined amount is automatically deducted irrespective of the market level or NAV, SIP investors of equity-oriented mutual funds automatically end up getting more units at lower net asset values (NAVs) during bearish markets.
Question of liquidity
Most banks charge a premature withdrawal penalty of up to 1% for premature closure of RD. In case of SIPs, liquidity would depend on the liquidity features of the mutual fund invested in. Those investing in equity-linked savings schemes (ELSS) funds through SIPs can only withdraw the units bought at least three years ago. While other mutual fund categories do not restrict redemption, most funds levy exit loads of up to 2-3% on redemption before a preset time. However, no exit load is levied in case of short-term debt funds such as the ultra-short duration, liquid, overnight and most low and short-duration debt funds.
Hence, short-term debt funds beat RDs in terms of cost incurred on unplanned redemptions. Similarly, equity mutual funds also outscore RDs in terms of unplanned redemption cost flexibility as most equity mutual funds do not charge exit load after one year of investment.
Tax implications
The interest income generated by your RD returns is clubbed with your annual income and taxed as per your income tax slab. In case of SIPs, taxation would depend on the type of mutual fund and the holding period.
Gains — short-term vs long-term
In case of equity-oriented funds, gains booked from redeeming investments within one year attract short-term capital gains (STCG) Tax of 15%. Gains booked from redeeming units in equity-oriented funds after one year of investment are considered Long Term Capital Gains (LTCG) and attract 10% tax on gains exceeding ₹1 lakh in a financial year. Moreover, SIPs in ELSS funds also qualify for tax deduction of up to ₹1.5 lakh per financial year under Section 80C.
In case of debt mutual funds, capital gains booked on redeeming debt fund after three years of investment are considered as LTCG and are taxed at 20% along with indexation benefits. Returns booked on debt funds redemption within three years are considered as STCG and are taxed as per the investors income tax slab.
(The writer is Director, Paisabazaar.com)
