Tax implications of investing in banking and PSU funds: What you need to know

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Banking and PSU funds have emerged as a popular investment avenue for conservative investors looking for potentially reasonable returns with high credit quality. While these funds carry relatively lower volatility compared to long duration funds, their tax treatment is similar to other open-ended debt funds. As an investor, it is important to understand the taxation nuances before investing in banking and PSU funds.

  • Table of contents
  1. Classification as debt funds
  2. Income tax on banking and PSU fund
  3. Banking and PSU funds vs. Fixed deposits
  4. Changes in tax regime
  5. FAQ

Classification as debt funds

Banking & PSU funds are categorized as debt funds as per taxation norms since a predominant portion of their portfolio is invested in fixed income securities like bank CDs, bonds, debentures issued by Public Sector Undertakings (PSU), Public Financial Institutions (PFI), etc. Even though these schemes invest in debt and money market securities issued by banks, PSU PFI etc, the tax implications are the same as regular debt mutual funds.

Income tax on banking and PSU fund

Capital gains tax on banking and PSU fund

Banking and PSU Fund are mandated by SEBI to allocate at least 80% of the total funds towards debt securities. This allocation classifies Banking and PSU funds as debt funds for taxation purposes.

Units purchased after April 1 ,2023 – Gains from Banking and PSU fund investments made after April 1, 2023, no longer receive indexation benefit and are considered to be short-term capital gains irrespective of the holding period. Therefore, they are added to the investor’s taxable income and taxed at the applicable slab rate.

For example, if you fall under the 30% tax bracket and redeem units resulting in a short-term gain of Rs. 50,000, you will have to pay a tax of 30% on the entire amount, which works out to Rs 15,000. Therefore, evaluate your income tax slab before investing in banking and PSU funds for less than 3 years.

,Units purchased before April 1 ,2023 – However, gains from investments made before April 1, 2023 – and held for a period of 36 months or more – are considered long-term capital gains and taxed at 20% with indexation benefit.

Suppose you invested Rs. 2 lakh in a Banking and PSU fund in 2018 and redeemed after 5 years in 2023 for Rs 2.8 lakh. During the same period, the inflation index increased from 280 to 337 over this period.

Hence, the indexed purchase cost works out to Rs. 2 lakh * (337/280) = Rs. 2.4 lakh

So, the long-term capital gain is Rs. 2.8 lakh – Rs. 2.4 lakh = Rs. 40,000. A 20% tax is levied on this Rs. 40,000, which works out to be is Rs. 8,000. Without indexation benefits, the tax implication would have been higher.

Banking and PSU funds vs. Fixed deposits

A common dilemma is whether to invest in Banking & PSU funds versus bank fixed deposits from a taxation standpoint. Here is a comparison:

  • Interest income from FDs is fully taxable as per applicable slab
  • Indexation not available on FD interest
  • TDS applies on FD interest above Rs. 40,000
  • Debt funds score over FDs on long term capital gains

Changes in tax regime

Taxation norms related to capital gains and interest income from debt mutual funds may change in future budgets. Investors should keep abreast of tax changes through official channels and plan investments accordingly.

Conclusion

Taxation should not be the sole driver for investing in Banking and PSU funds or debt mutual funds in general. Evaluate your asset allocation needs, time horizon, risk profile, investment objectives and expected returns before deciding on specific investments. Optimal tax planning can enhance post-tax returns from your mutual fund portfolio. When in doubt, do not hesitate to consult a financial advisor for customized investment recommendations.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.