Taxation Impact on Portfolios – Part 1
- Wealth Beacon Team
- Jun 5
- 2 min read
Updated: Jul 24
Understanding Post-Tax Returns in ‘Safe’ Instruments
Taxation is one of the most important, yet frequently overlooked, aspects of portfolio construction. It often plays a pivotal role in determining what investors actually take home. After all, investors cannot enjoy pre-tax returns – they can spend what remains after tax.
In this multi-part series, we aim to decode how taxation impacts various investment choices. In this first part, we explore how taxes influence returns in ‘Safe Instruments’ i.e. investments with low market risk. We compare three popular options: Fixed Deposits (FDs), Debt Mutual Funds (Liquid Funds), and Arbitrage Funds.
Fixed Deposits (FDs)
Fixed Deposits are simple, popular instruments where investors lend money to banks or government-backed institutions for a fixed tenure at a fixed interest rate. For non-senior citizens, typical 5-year FD rates currently range between 7% - 7.5%.
Tax Treatment:
Interest is taxable each year as per the investor’s income tax slab.
For those in the highest tax bracket (30%), this severely reduces the effective return.
Risk: Low, but not zero. The return depends on the bank’s solvency.
Liquid Mutual Funds
Liquid Funds invest in short-term debt instruments issued by high-quality corporations and the government. They are highly liquid (no lock-in) and generally stable.
Tax Treatment:
Tax is deferred till withdrawal.
Even though they are taxed at the same rate as FDs, the deferment till withdrawal provides compounding benefits.
Risk: Low default risk; fund management matters.
Arbitrage Funds
Arbitrage Funds exploit price differences between the cash and futures markets of equity stocks. Though classified as equity funds, their actual market risk is low, since they aim to maintain net-zero equity exposure.
Tax Treatment:
If held for more than 1 year, gains are taxed as long term capital gains (12.5% with the first ₹1.25 lakh exempt).
This significantly improves the post-tax return profile.
Risk: Low (compared to debt), but execution risk from algorithmic strategies does exist.
Post-Tax Comparison: 5-Year Holding
Let’s assume each of these instruments earns a 7% annual return from May 2025 to May 2030. Here's what post-tax returns would look like for an investor in the 30% tax bracket:
As is evident, arbitrage funds offer the highest post-tax returns, followed by liquid funds, and finally FDs. The compounding effect of tax deferral (Liquid Funds) and lower tax rate (Arbitrage) is significant.
Real-World Illustration (June 2022–June 2025)
Let’s also look at actual returns over the last 3 years. Once again, arbitrage funds come out on top.
Summary
When designing investment portfolios, post-tax returns should be a primary consideration – not just nominal interest or headline yield. In the case of low-risk instruments:
Arbitrage Funds offer the most tax-efficient growth.
Liquid Funds are superior to FDs due to tax deferral.
Fixed Deposits, while simple and safe, are often the least efficient from a tax standpoint.
In the next part of this series, we’ll explore how taxation affects different equity products.
Great content!