Ati sarvatra varjayate (Translated: Excess of everything is bad)
There are many avenues for NRIs to invest in the Indian markets. When it comes to a fixed income avenue, the NRE FD stands out as a preferred choice for NRIs, especially because the returns (around 7-8% per annum) are completely tax free in India and that it is not subject to market risks.
However, today I wish to explore the not-so-positive side of NRE FDs so as to help you take a balanced view and invest in these instruments knowing the pros as well as cons.
I have already discussed the tax and FEMA implications of NRE FDs in this post so request you to please check it out: NRO, NRE, FCNR, RFC: Tax and FEMA Implications for Returning NRI
Below are the pitfalls of investing in NRE FD:
#1: Investing in NRE FD hampers your long term wealth creation goal:
True, investing in NRE FD gives you a comfort of tax free guaranteed kind of return from your investment – however, the simple mantra of creating long term wealth requires you to invest in instruments which, over the long term (10+ years) yield significantly higher than the prevailing inflation rate.
If you plan to retire back to India and want to build a rupee portfolio, assuming an inflation of 8%, a 7-7.5% return from NRE FDs is simply not helping the cause. In a way, it can just help you stay afloat, but not swim faster to your goal.
Compared to that, a larger allocation to equity especially till you are 40-45 can help you reach your financial independence goal faster, OR require a lower monthly investment commitment by way of an SIP investment.
So, if you are under 40 and a major portion of your portfolio (like 60-70%) is invested in NRE FDs, there’s a good chance you will repent later of not taking a higher risk and investing in equities – of course this is a very generalised statement and may not apply to all.
Solution (and I’m going to discuss it later in the article) is that arrive at an ASSET ALLOCATION. Have a very aggressive asset allocation when you’re young (say 70% in equities and 30% in fixed income) – the NRE FD should only form part of this 30% component, nothing more.
This approach will help you aggressively build a corpus for your retirement and other long term financial goals.
#2: Tax Implications may apply in your host country:
NRE FD is tax free in India, but does that mean it is also a tax free in your host country?
May be yes, may be no.
Understand this: If you live in a country, irrespective of your Indian citizenship, you may be a “resident” of that country from the perspective of country’s tax law.
Now some countries like India, USA etc. follow the “classic” system of taxation where a resident is taxed on his global income.
On the contrary, countries like Singapore, Korea etc. follow the “territorial” system of taxation where the income earned outside that country is not taxed.
Then we have the entire Gulf belt (countries like UAE, Oman, Qatar etc.) which do not impose personal income tax – this means the question of taxing Indian income in such a case does not arise.
Let us understand this with the help of following examples:
- A, an NRI, lives in USA. He is a resident alien as per US tax law. His income in India (including tax free interest from NRE FD earned in India) will be taxed in USA.
- B, an NRI, lives in Singapore. His income from India (including tax free interest from NRE FD earned in India) will not be taxed in Singapore.
- C, an NRI, works in UAE. None of his worldwide income will be taxed in UAE.
From this analysis, one thing is clear: NRE FD may not be a tax free FD in all situations and depends on which country you’re located. If you are a USA based NRI, the effective post tax interest income will be 5-6% ONLY. Yes, the FD is a good option if NRI is located in countries/regions like Middle East, Singapore etc.
Speaking of USA based NRIs, there are also additional reporting requirements viz. FBAR and Form 8938 reporting, I have written on these topics:
IRS Form 8938 Reporting by US NRI
IRS Foreign Bank Account Reporting (FBAR) by US NRI
It is my personal observation that in many cases, the USA based NRIs is not at all aware of IRS implications on these incomes and this ignorance can land them in a soup later on. There is something like Streamlined Offshore Compliance Procedures that such NRIs can opt for, to come out of the mess and I advise them to consult a CPA asap.
#3: NRE FDs carries currency risk & conversion cost:
A lot of NRIs get lured by the higher yields offered by these deposits. However, one has to understand that there is a hidden risk of currency depreciation when you invest in such deposit.
Assume you are a US citizen having no plans to return to India. You get 0.5-1% yield on fixed income back in USA & as compared to that, the yield of 7.5% tax free in India seems a mouth watering deal. Even at a post tax 5-6% (considering US tax), you feel it is not a bad deal, no?
Here you’ve to understand that you send US dollars to India which the bank converts to INR to invest in India. The exchange rate bank gives you is not a real rate for e.g. if the prevailing rate is 67, bank may offer it to you at say 66. So, you create an NRE FD for Rs 66 and not Rs. 67
However, conversion cost is a small issue. Bigger issue is that of currency depreciation. Some years down the line, when you withdraw the FD to remit it back to the USA, the exchange rate at that point will have a big bearing on your effective return on the FD.
Going by the history of how USD/INR exchange rates have worked over the years, there has been, on average 3-4% INR depreciation per year against the USD. And if that happens in your case, and exchange rate after 5 years is say 80, it can substantially wipe out all gains from interest income from these FDs in India.
Also note that while converting back to USD, the bank will give you a rate of say 81, which again is an effective cost of currency conversion and further lowers your return from these FDs.
#4: Lock In and foreclosure penalty implication:
There are two important points to note before investing in NRE FD, and that is a) if you withdraw before one year, you will not get any interest and b) in case even if you withdraw after one year but before maturity, a 1% interest penalty may apply. As regards lock-in, note that there is no lock-in per se in the strict sense of the term, only that if you withdraw before 1 year, bank will not pay you any interest.
This simply means that NRE FD should only be made if you are sure you’ll not need the money for atleast 1 year. Also, the FD must be tagged to a financial goal, so that a) you get a rough idea on the acceptable tenure of the FD and b) you can decide on the FD amount in the context of the asset allocation for that goal.
So, we learn here that despite NRE FD promising high tax free yields, it SHOULD NOT be considered as a contingency fund. Yes, an opposite view can also be taken on this, but I personally prefer liquid MFs and bank balance for contingency fund, as compared to NRE FD. I have also written a post on contingency fund for NRI: NRIs: First create emergency fund, then do long term investments
#5: NRE FD becomes taxable from the day your return to India:
This point is especially important for those NRIs who plan to return to India in near future. In one of my earlier posts NRI Definition: FEMA Act VS Income Tax Act and NRO, NRE, FCNR, RFC: Tax and FEMA Implications for Returning NRI I had told that from the day a person returns to India, he becomes a resident under FEMA and lose the tax free status.
So, if you are investing in NRE FD for your long term financial goal say retirement but you also know that down the line you may return back to India, you will have to make a fresh assessment on this investment near the date of your return to India.
After your return to India, you are allowed to “continue” these FDs till maturity. So the risk is this: if out of ignorance or by intention, you fail to disclose the interest earned on these FDs (proportionate interest for the part of year you became resident), it can count as concealment of income & the Assessing Officer can slap interest as well as penalty for concealment of income and at that point, you cannot claim ignorance of this tax rule.
In a separate post, I will discuss on the issue of NRE FD strategy for Returning NRI and post a link here as well.
#6: NRE FD is not insured in India:
It is critical that your investment portfolio is “diversified” – putting entire fund in NRE FD not only hampers wealth creation (as discussed above) but also carries a default risk. Investing in NRE FD with a bank essentially amounts to giving a loan to the bank for a fixed period.
Now, imagine a situation where the bank collapses: yes, it happened in the USA (which nobody thought) and why do we think it cannot happen in India too? Though we have a very strong regulatory oversight by our banking regulator RBI, you don’t know when and how things can go wrong.
In the USA, you have something like FDIC which protects a US consumer’s deposits and retirement accounts upto USD 2,50,000 – check this link In India, we have a desi version of FDIC known as Deposit Insurance and Credit Guarantee Corporation (DICGC) – this insurance is upto INR 1 lac per bank branch.
If you have substantial savings in NRE FD say a crore or two, the DICGC protection can amount to almost nothing.
In such a scenario, even if you wish to maintain NRE FDs, you can ensure that instead of one bank, the amount is split into 2-3 banks. Also, DO NOT invest in NRE FDs with co-operative banks as they are poorly regulated – see this moneylife article
What should be the right NRE FD investment strategy?
The fact that you are getting a very high tax free yield on your investment in India as compared to your host country should not dictate your investment decision in isolation. You need to look at it holistically.
You need to decide on whether and when you are looking at returning back to India, the amount you’re planning to invest in NRE FD is going towards which financial goal and the other investment opportunities available to you.
If you’re a USA based NRI (or other countries which tax global income of tax resident), know that 7.5% is an illusion, it is much lower than that. Even then, investing in NRE FD will make sense because of the restrictions imposed by Indian MFs on accepting funds from people from these countries, in view of the SEC and FATCA related compliances – see this Moneylife article
For other countries, like Singapore and UAE, NRE FD is an excellent investment for the debt component of your portfolio.
So, for example, you plan to retire back in India, and are planning for that goal, then NRE FD can be a very good avenue for the debt component of the portfolio – for growth component, you should just look at equity, plain and simple – it can be direct or via direct plans of mutual funds, depending on your preference and temperament.
So, long point short: NRE FD is an excellent investment option, but when people go overboard on it, they can sacrifice their wealth creation possibilities. Hence, invest in NRE FD but in moderation and in alignment with your financial goals and asset allocation.
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