Debt Watch. A small savings scheme shoot-out

It’s that time of the year when the government resets the rates on small savings schemes. But surprisingly this year the Centre has kept rates unchanged, despite the sharp fall in government bond yields by over 100 basis points in the past year.

Post office term deposits for five years now offer 8.5 per cent. Five-year and 10-year NSC carry interest rates of 8.5 per cent and 8.8 per cent, respectively.

The Government has also held the rate on the PPF steady at 8.7 per cent.

Coming as an additional relief to senior citizens, the government has increased the rate on the five-year Senior Citizen Saving Scheme by 10 basis points to 9.3 per cent. The government has also increased the interest rate for its recently launched Sukanya Samriddhi Scheme for the girl child to 9.2 per cent.

All these rates will come into effect from April 2015. So, which is a better option after these tweaks — post office schemes or bank deposits?

Rates on bank fixed deposits have been trending lower by 50 to 75 basis points across different tenures in the last one year. Five-year bank deposit rates now offer between 8.5 and 8.75 per cent — the best rate offered is 9 per cent.

Interest rates on bank deposits may still appear more attractive than small savings schemes. But there is the tax aspect to consider.

The principal invested under all small savings (except FDs for less than five years) and tax-saving bank deposits are exempt under Section 80 C, up to ₹1.5 lakh.

But your tax liability on the interest earned differs.

Interest earned on bank deposits as well as post office deposits is taxed at your income tax slab rate. Hence, a bank deposit that earns you 9 per cent (best rate) or even 8.75 per cent trounces the post office deposit. But in the case of NSC, interest earned is accumulated until the fifth year and is eligible for tax exemption. Only the fifth interest is taxable. Do note that this applies only to people who have room under Section 80C and haven’t exhausted the ₹1.5-lakh annual limit. For such investors, NSC offers better post-tax returns than bank deposits.

After factoring in the initial tax savings for the 10, 20 and 30 per cent tax brackets, the five-year NSC ends up offering effective returns of 10.7, 13.3 and 16.3 per cent, respectively. This is higher than the 10.5, 12.4 and 14.7 per cent that the best tax saving bank deposits (at 9 per cent) offer on comparable basis. Hence, NSC clearly trumps bank deposits for a five-year period.

If you want to park your money for 10 years, banks have hardly any instruments on offer. But the post office offers both the 10-year National Savings Certificate and the Public Provident Fund (PPF).

The 10-year NSC will continue to offer an interest rate of 8.8 per cent from April 1. The tax benefits are similar to the five-year NSC, but can be availed only by those with room under Section 80C. Interest of 8.7 per cent from PPF, on the other hand, is completely tax-free.

After taking into account the initial tax savings, the yield comes to 11, 13.8 and 17 per cent in the 10, 20 and 30 per cent tax brackets, respectively. The rate on PPF is subject to change every year. But given that rates have not been tweaked for 2015-16, PPF remains the best option for the long haul.

If liquidity matters to you, then remember that both NSC and PPF have fairly complex rules for withdrawal. In the case of NSC, you can withdraw prematurely only in the case of death, forfeiture by pledge or through a court order. Also, the amount you can withdraw is worked out based on simple interest. In the case of PPF, the investments are locked in for a period of 15 years and partial withdrawals are allowed after the end of the sixth year. In the case of tax-saving bank deposits, premature withdrawal is not allowed.