Understanding the tax implications of debt funds

Debt funds are mutual funds that primarily invest in fixed-income securities, such as government bonds, corporate bonds, treasury bills, and other money market instruments. Debt funds are considered to be relatively less volatile than their equity counterparts, making them a favourable choice for those looking for relatively stable returns.

However, with recent changes in the tax on debt funds in India, understanding the tax implications of debt funds is crucial before making an investment.

Situation before April 1, 2023

Short-Term Capital Gains (STCG): For units of debt mutual funds that are sold within three years of purchase, the gains are considered short-term. Historically, investors had to pay tax on these gains as per their respective income tax slab rates

Long-term capital gains (LTCG): Previously, if the units of a debt fund were held for more than three years and then sold, the profit was classified as LTCG. This gain was taxed at a flat 20% rate after accounting for indexation benefits or at 10% without the advantage of indexation.

New taxation rules – Current scenario

However, there has been a significant shift in debt mutual fund taxation w.e.f. from April 1, 2023.

Impact of tax changes: The alteration in the tax on debt mutual funds may influence the attractiveness of these instruments, especially for long-term investors in higher tax brackets.

• The LTCG benefits and indexation advantages on debt mutual funds will no longer be available.
• For funds purchased on or after April 1, 2023, any capital gain will be added to the individual's income and will be taxed according to their slab rate.

However, these tax changes will not impact investments made until March 31, 2023, as those will continue to be eligible for the earlier LTCG tax benefits.

Impact of tax changes

The alteration in the tax on debt mutual funds may influence the attractiveness of these instruments, especially for long-term investors in higher tax brackets.

Previously, the availability of LTCG benefits with indexation made debt funds a preferable option over fixed deposits and bonds. But with the new changes, the arbitrage opportunities between varied debt instruments might be eradicated.

Debt funds vs Fixed deposits

Despite the taxation similarities between debt funds and fixed deposits, debt funds emerge as a compelling choice.

• Debt fund taxation only applies upon liquidation, allowing tax deferral.
• Additionally, regular FDs can impose early withdrawal penalties, while many debt funds have no exit load after a set period, ensuring better liquidity and cost-effectiveness.
• Unlike FDs, profits from debt funds are categorised as capital gains, enabling offsetting of debt fund losses against future gains and offering a tax edge

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.