For many, many years small investors didn't need to worry about paying tax on interest earned on bank deposits and certain post-office investment schemes and government securities, thanks to section 80L of the Income Tax Act.

Given that interest income upto Rs 12,000 was exempt from tax, you could invest up to Rs 150,000 in government bonds or much more in bank deposits without getting into the tax ambit. Now that is history.

So every penny of interest that you earn on your deposits -- government securities, post-office schemes and bank deposits -- is now taxable at your personal income tax rate. Don't fret. There is a way out: debt-based mutual funds.

Government bonds offer 8 per cent return per annum pre-tax (5.6 per cent post-tax if you are in the top tax bracket) but attract a lock-in period of six years. SBI's [Get Quote] deposit rate for a three-year period is 5.75 per cent. Here your effective return would be 4.02 per cent if you shave off 30 per cent tax.

Investments in debt funds can cut your tax liability to half or even lower, leaving more money in your hands. Dividend options of debt funds provide best post-tax returns if you are looking to invest for less than a year. Growth options are better if you invest for a longer term.

In the dividend plan, the gains that the fund makes is paid to you as dividends which are tax-free. The mutual fund pays a dividend distribution tax of 14.5 per cent which effectively reduces your return; still, you are better off than paying 30 per cent tax.

In the growth plan, gains are cumulated and reflected in the net asset value of the scheme. So when you sell units your income qualifies as capital gains (if it is a loss, it qualifies as capital loss). If units are redeemed within a year of investment, they qualify as short-term capital gains and get added to your income, attracting tax at your personal income tax rate.

However, if you sell units after one year they qualify as long-term capital gains and attract a flat 10 per cent tax or 20 per cent after accounting for indexation, whichever is lower.

Indexation benefit means that the money you invested originally, or your cost of acquisition of units or any other capital asset, is restated to account for inflation. So you end up paying tax only on the 'real' gains or what you got over and above inflation. Due to the indexation benefit, your tax liability can be lower.

But what kind of returns do these funds give? Debt-based mutual funds deliver returns ranging from 4 per cent to 7 per cent. Floating-rate fund and liquid funds are the safest and give returns in the range of 4-4.5 per cent.

Last one year, an average floater returned 4.73 per cent. If you invest today and earn at the same rate for the next three years, you will end up with a post-tax return of 4.59 per cent -- better than the SBI three-year deposit.

Floaters face the least risk of slipping since they invest in instruments where the interest rate is reset periodically depending on the prevailing market rate.

So while a fixed-rate instrument may lose value if interest rates rise -- because a fixed-rate bond will look unattractive compared to new debt instruments in a market that offers higher interest rates - floating rate instruments and hence funds which invest in such instruments escape this risk as the interest rate on instruments will get re-priced.

Similarly, liquid funds invest in short-duration papers the value of which does not fluctuate much. Short-term products can deliver better post-tax return even over the longer term.

But investors must probably be better off in medium-term debt funds. The past 18 months have been quite treacherous for these funds as rising interest rates knocked off the value of lower-yielding bonds held by them and impacted returns. Still, over the last three years debt funds gave returns ranging from 5.88 per cent to 9.05 per cent.

The three-year bank deposit rates of top commercial banks in 2002 were around 8.5 per cent. If you apply a 30 per cent tax rate, the effective post-tax return you would have earned is 6.09 per cent. If you had invested in a debt fund instead and it gave a return equivalent to the average of the top half (7.75 per cent), then your effective return post-tax would have been 7.03 per cent.

Even if your fund belonged to the bottom half category (6.76 per cent), your post-tax effective return would have been 6.23 per cent - higher than what you would have earned in your bank deposit. Only five of 31 medium-term debt funds fared worse than bank deposits on a post-tax basis.

The last three years were both good and bad. And funds did better than bank deposits. Over the next three years, if we have average to good years, debt funds could beat bank deposits comfortably.

A fund manager has to produce a return of only 4.1 per cent so that investors are not worse off than investing in bank deposits on a post-tax basis. Can fund managers deliver better than that? The odds are stacked in their favour.

However, if you are a senior citizen and your annual income is less than Rs 150,000 you don't need to worry about taxes. You can safely invest your money in a senior citizen deposit scheme, which is available with select public sector banks and even post offices.

You can invest upto Rs 15 lakh (Rs 1.5 million) here and get a return of 9 per cent. The next best option is the post-office monthly income scheme - it fetches 8 per cent per annum with a 10 per cent terminal bonus.