NSC or 5-year FD? Which is the better tax-saving investment option? (2024)

What is a five-year tax-saving Fixed Deposit?

A fixed deposit is a financial instrument where the investor can invest a lump su with a bank at a fixed interest rate for a specified period of time. One can invest the amount from 7 days up to 10 years. Upon maturity, the investor will receive the amount that was invested along with the interest. One among them is tax saving fixed deposit which offers tax deduction under Section 80C of the Income Tax Act,1961. The quantum of the deduction depends on the investment made. Therefore, investors can save tax up to a maximum of Rs 1,50,000 by investing in a tax saving FD. However, the tax-saving FD comes with a lock-in period of 5 years. Also, the interest earned on FD is taxable as per the applicable income tax slab rate. FDs can be renewed automatically. One need not visit the bank for its renewal. Further, the interest accrued on tax saving FD is subject to a TDS of 10 per cent if the interest income exceeds Rs 40,000 (Rs 50,000 for senior citizens).

According to Jain, beyond these key differences, there are a few other points to consider when making your choice such as:

Premature withdrawal: Both NSCs and tax-saving FDs lock your money away for 5 years. While early withdrawals are sometimes possible in FDs with some penalties involved, NSC investments do not allow any premature withdrawal of funds. You can only withdraw after 5-years of lock-in unless there is a special case like the death of the investor.

As per Scripbox, one can withdraw from NSC before maturity only under specific conditions like –

1. The demise of the certificate holder
2. On the forfeiture of the certificate by the gazetted officer
3. On order from a court of law
4. Withdrawal from both schemes will not fetch any interest. Investors are liable to a penalty on premature withdrawal.

Interest payouts: NSCs only pay out interest annually and the interest accumulated is reinvested and paid at the end of the fifth year. FDs, however, offer more flexibility with monthly, quarterly, or yearly payout options. Choose the option that best suits your needs, depending on whether you prefer receiving regular income or a lump sum at the end.

Earning potential: Although both options earn interest, NSC generally offers higher interest rates compared to a FD. However, FDs tend to benefit slightly from more frequent compounding (usually quarterly) compared to NSCs' annual compounding. This can lead to a better overall yield over the 5 years.

Tax implications: While both FD and NSC offer benefits under IT (S) 80C, in the case of NSC the entire interest earned can also claimed for deducted under under Section 80C. FDs, on the other hand, only allow you to deduct the initial investment amount, not the interest. Interest income earned on both is taxable, in NSC no TDS is deducted but in FDs TDS (tax deducted at source) is applicable if your interest income exceeds a certain limit.It is deducted at 10 per cent if the interest income exceeds Rs 40,000 (Rs 50,000 for senior citizens).

"The interest earned on NSC and tax saving FDs is taxable in the hands of the investor under the heading ‘Income from Other Sources.’ However, the interest earned on NSC is not paid out to the investor. Instead, it is reinvested and this interest amount is eligible for tax benefit under section 80C. To avail the benefit of interest on NSC, the investor has to first show the interest accrued under Income from other sources and then claim tax deduction under Section 80C within the limit of Rs. 1.5 lakh," explained Scripbox.

Investment Amount:

NSC: Minimum Rs. 100, no upper limit.

FD: The minimum varies by bank, but the maximum for tax deduction is Rs. 1.5 lakh.

Liquidity:

NSC: Locked-in for 5 years, with premature withdrawal penalties.

FD: Typically locked-in for 5 years, with some banks offering premature withdrawal options but at a penalty.

Risk:

What to choose between Tax-saving FDs and NSC?

When evaluating investment options, investors must consider all relevant factors. Additionally, it's important to note that interest accrued on both NSCs and FDs is reinvested rather than distributed as income. Consequently, these schemes are most suitable for individuals who don't require regular income.

"From a broader perspective, NSCs, due to their lack of liquidity, are better suited for long-term objectives such as retirement planning. On the other hand, FDs offer greater flexibility as they can be prematurely withdrawn when funds are needed urgently," said Adhil Shetty, CEO of Bankbazaar.

Chakravarthy V, Co-founder and Executive Director at Prime Wealth Finserv Pvt. Ltd explains this with an example:

Consider that you invest Rs 1 lakh in both NSC and FD (assuming 30 per cent tax bracket):

NSC:

1. Interest earned after 5 years (compounded annually) = Rs. 39,455.56
2. Tax benefit under Section 80C = Rs. 1 lakh (This already accounts for the interest earned)
3. Effective post-tax return = Rs. 1 lakh + Rs. 39,455.56 = Rs. 1,39,455.56

Fixed deposit (assuming 7 per cent p.a. interest):

1. Interest earned after 5 years (compounded quarterly) = Rs. 40,578.62
2. Tax on interest income (assuming no TDS deduction) = Rs. 12,173.58 (30 per cent of Rs. 40,578.62)
3. Effective post-tax return = Rs. 1 lakh (investment) + Rs. 40,578.62 (interest) - Rs. 12,173.58 (tax) = Rs 1,28,405.04
4. Based on this calculation, NSC offers a slightly higher effective post-tax return in this scenario

However, it's crucial to consider other factors:

Senior citizens can get higher FD rates and avoid TDS, potentially making FDs more beneficial.

Liquidity needs: If you might need the money before 5 years, FDs with premature withdrawal options might be more suitable.

Chakravarthy believes one should choose NSC if one wants:

1. Slightly higher potential returns (especially for non-senior citizens).
2. Lower risk (backed by the government).
3. Long-term investment goals where you don't need the money before 5 years.

One should choose the five-year FD if

1. Potentially higher interest rates (if you qualify for senior citizen benefits or find a bank with a very competitive rate)
2. More flexibility with some banks offering premature withdrawal options.
3. Shorter-term investment needs where you might need the money before 5 years (but be aware of penalties).