Updated tax regulations for debt mutual funds: What investors need to know

When investing and calculating potential returns, it’s important to consider tax implications on returns to ascertain the true value of your investments. Investing without factoring tax implications can lead to unexpected tax liabilities and missed tax-saving opportunities.
The Union Budget of 2023 made significant changes to the taxation regime for debt mutual funds. The 2024 Budget upheld these and made further changes to units purchased before April 1, 2023.

This article will take a closer look at updated tax regulations for debt mutual funds so that you can plan your investments effectively. But first, let’s understand what a debt fund is.

• Table of contents

1. What are debt mutual funds?
2. Taxation of debt mutual funds
3. New amendment and its impact
4. How proposed changes would impact tax outflow

What are debt mutual funds?

With debt mutual funds, one can invest in various fixed income securities, including treasury bills, corporate bonds, commercial papers, government securities, and other money market instruments. These securities have predetermined maturity dates and interest rates, providing investors with fixed income upon maturity, hence the term "fixed-income securities".

Taxation of debt mutual funds

Until March 31, 2023, capital gains arising from the redemption of a debt fund held for at least three years were categorized as long-term capital gains (LTCG) and were subject to a fixed tax rate of 20% after indexation. For units held for less than three years, capital gains would be taxed as per the investor’s income tax slab.

New amendment and its impact

From April 1, 2023, onwards, capital gains earned from debt mutual funds, exchange-traded funds (ETFs), international funds, gold funds, and specific categories of hybrid funds that invest less than 35% in Indian equities will be included in your taxable income and subject to taxation at the applicable slab rate, irrespective of the holding period. The previously available long-term capital gains (LTCG) tax benefits and indexation benefits on debt mutual funds will no longer be applicable.

Debt funds and equity funds usually have a minimum of 65% of their investments in debt securities or equities, respectively. However, as per the new tax rule, non-equity funds with less than 35% of investments in equities will no longer be eligible for the long-term capital gains (LTCG) tax rate of 20% with indexation, effective from April 1, 2023. This tax advantage was a significant reason why many investors preferred debt investments, but it is no longer available.

However, till Budget 2024, the indexation benefit was applicable to units purchased before April 1, 2023. That is no longer the case. Now, units purchased before April 1, 2023, will be eligible for long-term capital gains tax after a holding period of 24 months (instead of 36 months). The LTCG tax rate will be 12.5% (instead of 20% with indexation).

The indexation benefit on hybrid funds investing more than 35% but less than 65% in Indian equity was also removed. For this category, gains on units held for less than 24 months will be taxed as per the slab rate. Gains on units held for more than 24 months will be taxed at 12.5%.

For debt fund units purchased after April 1, 2023, there is no change. These units will be added to the investor’s annual income and taxed as per the applicable slab rate.

How proposed changes would impact tax outflow

Tax efficiency plays a significant role in driving investment decisions across various avenues, including insurance, bonds, mutual funds, equities, NPS, PF, and alternative investments. Investors tend to prefer avenues with lower taxation on returns. Therefore, the changes to capital gains taxes on certain hybrid mutual funds and all debt mutual funds may affect their attractiveness to investors. However, their return potential and liquidity advantage may still make them more attractive than other avenues such as savings accounts, short-term fixed deposits, and recurring deposits.

FAQs:

What are the types of tax on debt mutual funds?

Debt funds are subject to two types of taxes based on their holding period, namely short-term capital gains (STCG) tax and long-term capital gains (LTCG) tax.

How much tax do you pay on debt mutual funds losses?

As per the Income-tax Act, an individual is allowed to offset their losses against taxable profits. However, long-term capital losses can only be set off against long-term capital gains and cannot be set off against short-term capital gains, despite both falling under the same head of capital gains.

Are debt mutual funds tax-free?

No. Debt fund investments will be subject to taxation based on the applicable slab rates. The previously available long-term capital gains (LTCG) tax benefits and indexation benefits on debt mutual funds will no longer be applicable.

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 an 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.