Arbitrage Funds Emerging as Tax Efficient Alternative to FDs and Savings Accounts

Retail investors looking for a parking ground for short- to medium-term money are increasingly comparing arbitrage mutual funds with traditional fixed deposits (FDs) and savings bank (SB) accounts. Recent return and tax-efficiency trends show that arbitrage funds can deliver better post-tax outcomes for many taxpayers without locking money for long periods.

FDs Offer Safety but Full Taxation

Bank FDs continue to be the default option for risk-averse savers. They offer guaranteed returns but the interest is taxed at the investor’s marginal slab rate. For taxpayers in the 20%–30% brackets, this sharply reduces the net yield. SB interest enjoys limited exemptions but rates are far lower than either FDs or arbitrage funds.

Arbitrage Funds: Equity Taxation, Low Risk Strategy

Arbitrage funds invest simultaneously in cash and futures markets to capture price differentials. For tax purposes, they are treated as equity-oriented mutual funds. Gains on units held for over a year fall under the long-term capital gains (LTCG) regime: the first ₹1.25 lakh of annual gains is currently exempt, and the balance is taxed at 12.5%. Short-term gains (≤ 1 year) are taxed at 20% plus cess still competitive for those in higher slabs.

Sample calculations illustrate the gap:

• A ₹10 lakh FD at 7% yields ₹70,000 pre-tax but only about ₹48,000 after tax for a 30% bracket investor.
• The same money in an arbitrage fund at 7.2% (per annum average return) can deliver the full return tax-free if held beyond a year within the exemption band.

For low-tax-bracket investors needing money within a year, FDs may still edge out arbitrage on an after tax basis. But for middle and high brackets, arbitrage funds often win even for short periods. Below is the tabular presentation showing the benefit: 

 

Liquidity and Risk Considerations

Unlike FDs, which levy penalties for premature withdrawal, arbitrage funds allow easy redemption with no hard lock-in though most levy a small exit load if withdrawn within 30 days. They are considered low-risk relative to equity funds but are not government-guaranteed. Market, liquidity and operational risks remain. FDs retain an edge for investors who prize absolute safety over post-tax yield.

Tax Compliance Easier

Banks deduct TDS on FD interest above thresholds and the income must be reported annually and tax is payable on annual basis. Whereas in Arbitrage funds tax is payable only at the time of redemption.

Conclusion

For savers seeking capital preservation with better post-tax returns and flexibility, arbitrage funds are emerging as a compelling alternative to FDs or leaving large balances in savings accounts particularly for those in higher tax brackets.

Disclaimer: This article is for general information only and does not constitute investment or tax advice. Investors should consult their financial / tax adviser before investing.

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