BackYour Questions Answered: I'm a 33-year-old government employee and want to know how debt mutual funds are taxed?
The government has removed the tax arbitrage from debt mutual funds, which may result in investors switching to corporate bonds and bank fixed deposits for their fixed income investments.
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Q. I am a 33-year-old state government employee, my wife is also a state government employee. We have been investing 20% of our income in mutual funds every month. We invest about half of our investment budget in debt mutual funds and half of our investment budget in equity mutual funds. We understand from TV news that recently major changes have been made to the tax regime pertaining to the debt mutual funds through an amendment to the finance bill. Can you please elaborate on the same and also please compare the taxation of debt mutual funds against fixed deposits?
Neha Sen, Darjeeling, West Bengal
Uptill now investors were either liable to pay long term capital gains tax or short term capital gains tax on their debt mutual fund units depending on the time period of their investment. Long-term capital gains tax applies to investments in debt mutual funds held for over three years.
They are taxed at 20% with an indexation benefit. Indexation is a method that adjusts the purchase price of an investment for inflation, which reduces the tax liability on the investment.
Short-term capital gains tax applies to investments in debt mutual funds held for three years or less. These short-term capital gains are taxed at the income tax slab rate of the investor.
Debt Mutual Fund - Historic Tax Advantage
Historically, compared to fixed deposits, lower tax rate on long term holding of debt mutual funds use to make debt mutual funds a desirable post-tax option for long-term investors in the higher income tax slabs. Essentially because interest from fixed deposits is taxed at the individual's income tax slab rate and also because indexation benefits associated debt mutual funds.
Keep in mind that indexation of capital gains is effectively an adjustment for inflation. It is neither a tax break nor a government handout. It is intended to make up for inflation, the deterioration of money's worth over time, and the fact that many ostensible gains throughout the years have actually been illusions. Because money now is intrinsically worth less than it did when you made your investment, this illusion is produced.
In any case, this depreciation of currency is a consequence of government activity. You shouldn't have to pay taxes on whatever fictitious gains you make from inflation.
Finance Bill 2023
This distinction between debt fund taxation for holding periods of under three years and three years or longer will no longer hold in light of the most recent changes introduced in form of an amendment to the Finance Bill, 2023. Debt mutual funds purchased on or after April 1, 2023, will be taxed at your income tax slab rate.
However, please note that all of your existing investment in debt mutual funds and even any fresh investment made in debt mutual funds until 31st March, 2023 will be grandfathered and will be taxed as per the existing taxation regime, i.e., 20% tax on long term capital gains along with indexation benefits.
It is important to understand this new taxation regime will be applicable to all mutual funds which have less than 35% of their corpus invested in Indian equities, as a result lower LTCG taxation benefits has been taken away from the following categories of mutual funds:
- International funds launched by Indian mutual fund houses.
- Gold funds.
- Majority of funds of funds.
- All other mutual funds are classified as debt mutual funds.
The proposed change in tax laws adhere to the principles of the new, exemption-free default personal income tax structure. The tax system in India is becoming more straightforward and uniform, with no possibility for tax exclusions or arbitrage.
Fixed Deposit vs. Debt Mutual Funds
From a taxes standpoint, fixed deposits and debt mutual funds are on an equal footing. The tax arbitrage between debt funds (capital gains) and fixed deposits (interest income) is no longer present.
However, debt funds still make more sense for many investors when compared to bank fixed deposits. This is due to two factors. The greatest difference between fixed deposit and debt funds is that for most fixed deposits returns do not accrue over time. TDS on interest is charged to and transferred out of fixed deposit every quarter. On the other hand, taxes on mutual funds are postponed until redemption.
Hence, an individual can make more money by investing in a debt mutual fund even if the rate of return is theoretically the same - by redeeming them during his retirement period when he is in a lower income tax slab.
However, it must be noted that there will be no indexation benefit associated with debt mutual funds. Previously, the indexation benefit was used to significantly reduce the tax liability for long term investors. Denying indexation benefits eliminates the idea of long-term tax-efficient compounding in a low-yield asset class like debt mutual funds.
Better liquidity is the second advantage that debt mutual funds have. A debt fund may be redeemed at any moment. However, in the case of fixed deposits early withdrawal often attracts a penalty.
Conclusion
Debt mutual funds have been a popular investment option amongst long term investors because of the tax arbitrage which existed between debt mutual funds and other fixed income asset classes such as fixed deposits and bonds. The government has now removed this tax arbitrage which may result in less and less people investing in debt mutual funds and in place of that investing in corporate bonds and banks’ fixed deposits.
Kuvera is a free direct mutual fund investing platform.
Note: This is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.
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