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.

What are debt mutual funds?

Debt mutual funds are mutual fund schemes that invest predominantly in fixed income securities issued by governments, public sector entities, financial institutions, and companies. These instruments may include government securities, treasury bills, corporate bonds, certificates of deposit, and commercial paper. The primary objective of debt mutual funds is to generate potential returns through interest income or changes in the market value of underlying assets, while managing interest rate risk and credit risk.

Taxation of debt mutual funds before April 1, 2023

Short-Term Capital Gains (STCG): For units of debt mutual funds that were sold within three years of purchase, the gains were considered short-term. 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.

Post 2023 taxation rules – Current scenario

There was a significant shift in debt mutual fund taxation w.e.f. from April 1, 2023.

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

Further, post Budget 2024, debt fund units purchased before April 1, 2023, are taxed as follows:

• Short-term capital gains tax: This is applicable on units acquired before April 1, 2023. Units held for up to 2 years will be taxed as STCG as per applicable slab rate.
• Long-term capital gains tax: Capital gains on units acquired before April 1, 2023, and held for more than 24 months will be taxed at 12.5% with no indexation benefit.

Note: Tax rates above exclude applicable surcharge and cess.

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. Before making a substantial one-time investment, you can use a lumpsum calculator to estimate potential post-tax returns.

Debt funds vs fixed deposits

Despite the taxation similarities between debt funds and fixed deposits, debt funds may be a suitable 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

Returns on fixed deposits are fixed, however, returns on mutual funds are subject to market risks

What is indexation and how does its removal affect taxation?

Indexation is a tax calculation method that adjusts the purchase cost of an investment to account for inflation over the holding period. By increasing the cost base using the government-notified cost inflation index, the taxable capital gains are reduced.

As mentioned earlier, indexation benefits have been removed for debt mutual funds in India. This affects taxation in the following ways:

• Inflation adjustment is no longer available to reduce taxable gains
• Tax liability is now directly linked to the investor’s income slab, which may influence post-tax potential returns.
• Longer holding periods no longer provide a separate tax rate advantage for new debt fund investments.

IDCW taxation on debt mutual funds

IDCW (income distribution cum capital withdrawal) payouts from debt mutual funds are taxable in the hands of the investor. The entire amount received as IDCW is added to the investor’s total income for the financial year and taxed according to the applicable income tax slab rate. There is no separate or concessional tax rate for IDCW income, irrespective of the holding period of the mutual fund units. TDS may apply if IDCW income exceeds a certain threshold.

Tax-saving strategies for debt fund investors

While debt mutual funds no longer enjoy indexation benefits, investors may still evaluate certain strategies that focus on managing tax impact without making return assurances or speculative assumptions. These include:

Conclusion

Understanding the tax implications of debt mutual funds is essential for setting realistic expectations around post-tax potential returns. Recent regulatory changes, particularly the removal of indexation benefits for most debt fund investments made after April 1, 2023, have altered how these funds are evaluated from a taxation perspective. Capital gains are now taxed as per the investor’s applicable slab rate, making tax outcomes more individual-specific. Rather than focusing only on headline returns, investors may benefit from examining how taxation, expenses, and market-linked risks interact over the holding period.

Frequently Asked Questions

How are capital gains on debt mutual funds taxed after April 1, 2023?

Capital gains from debt mutual funds purchased on or after April 1, 2023, are taxed at the investor’s applicable income tax slab rate, regardless of the holding period. There is no distinction between long-term and short-term gains and indexation benefit is not available.

What is the difference between short-term and long-term capital gains on debt mutual funds?

Before April 1, 2023, short-term capital gains tax applied to debt fund units held for up to three years and were taxed at slab rates. Long-term capital gains tax applied to units held for more than three years. Such gains were taxed at 20% percent with indexation benefit. The distinction between long-term and short-term gains does not apply to investments made after April 1, 2023.

What is indexation and how does it affect debt fund taxation?

Indexation adjusts the purchase cost of an investment for inflation using government-notified cost inflation indices. Before April 1, 2023, debt mutual fund investments used to enjoy indexation benefits on long-term capital gains, which potentially lowered tax liability. This benefit is no longer available for debt funds.

Are dividends from debt mutual funds taxable?

Income payouts from mutual funds are no longer termed dividends, they are called Income Distribution cum Capital Withdrawal (IDCW) payouts. IDCW payouts from debt mutual funds are fully taxable in the hands of investors. Such income is added to total income and taxed at the applicable slab rate.

Can I offset losses from debt mutual funds against other capital gains?

Capital losses from debt mutual funds may be set off against capital gains as per income tax rules. Short-term losses may be adjusted against both short-term and long-term gains. Long-term losses (only for investments made before April 1, 2023) may be adjusted only against long-term gains and may be carried forward for eight assessment years.

What is the holding period for debt mutual funds to qualify for long-term capital gains?

For debt fund investments made after April 1, 2023, all capital gains are deemed to be short-term capital gains. That is, there is no separate long-term capital gains tax for debt mutual funds.

Debt funds vs fixed deposits: which is better post-tax?

Post-tax suitability between debt mutual funds and fixed deposits depends on individual tax slabs, holding periods, and liquidity needs. Debt funds offer liquidity and market-linked potential returns, while fixed deposits provide predictable interest, subject to reinvestment and interest rate risk.

Returns on fixed deposits are fixed, however, returns on mutual funds are subject to market risks