Debt fund or FD: What should NRIs choose?

Both fixed deposits and debt funds are considered relatively safer investment options than equity funds.

But which of the two can be preferred?

Debt mutual funds can be generally chosen over fixed deposits, specifically if their holding period is more than three years. That is because, with such a broad holding period of over three years, these funds become more tax efficient.

Additionally, debt mutual funds (generally) generate higher returns and also provide liquidity. By liquidity, it is meant that the investors do not have to commit to any time or duration of the investment. That means, they can redeem the money whenever they want. But in case of fixed deposits, one needs to commit to the duration of the investment. Failure to do so will result in a penalty.

Furthermore, the interest earned on fixed deposits is added to the taxable income and taxed as per the applicable slab. Whereas, the gains on debt funds are taxed at 20 per cent (if the fund is held for at least three years), after adjusting the cost of purchase (investment) for inflation through indexation. For NRIs, the gains from mutual funds are also liable to TDS (tax deducted at source) at the time of redemption.

But there's a big attraction in case of fixed deposits for an NRI.

If one chooses to open an NRE (Non-Resident External) fixed deposit, the interest earned on the deposit is not taxed. It is completely tax-free in India.

An NRI can open two types of bank accounts and likewise, two types of bank fixed deposits - Non-Resident External (NRE) and Non-Resident Ordinary (NRO). Balances held in NRE accounts can be repatriated abroad freely, whereas funds in NRO accounts cannot be remitted abroad but have to be used only for local payments in Indian rupees.

State Bank of India (SBI) is currently offering an annual interest of 6.15 per cent on an NRE fixed deposit of three years. Good quality short duration funds are giving a somewhat similar return on pre-tax basis. There isn't a huge difference.

In conclusion
It is very important to check how the returns of the NRE fixed deposit will be taxed abroad (in the country of your current residence). Check the Double Taxation Avoidance Agreement (DTAA) for the same and consult a tax expert, if need be. If the return from NRE fixed deposit is going to be tax-free in your country or if a minuscule portion is charged as tax, then probably going for an NRE fixed deposit is a better option. You will get guaranteed tax-free returns.

But if you have to pay significant taxes on it in your country, or need liquidity and do not want to commit a duration for your investment, then probably short-duration funds would be a better option.