Taxation in Debt Mutual Funds

Debt funds are a good way to get inflation-adjusted returns in the long run. The unique aspect of a debt fund is that they are subject to indexation, which helps investors save tax on long term capita

Debt Mutual Funds significantly invest the money in fixed-income securities like government securities, debentures, corporate bonds and other money-market instruments. These products carry the low risk compared to Equity. They have low volatility and have potential to generate modest returns over time.

 

Tax on Debt Funds

Like other Funds, Debt Funds are also subject to capital gains tax, Short-Term Capital Gains Tax (STCG) & Long-term Capital Gains Tax (LTCG). If Debt funds are held for less than 3 years, then STCG is levied and if more than 3 years then LTCG is levied. Presently, the LTCG levied is 20% with indexation and STCG is taxed as per the investor’s tax slab. If the Investor’s Income Tax Slab is 20%, then the same will be levied on the Debt Funds gains in the case of STCG.

 

Indexation Benefits

Indexation is a tool that is applicable to long-term investments. It helps an investor to adjust inflation while gauging the returns of the invested amount.

As inflation is gradually rising, what’s worth Rs. 1000 could be worth Rs.1100 sooner in the near future. Thus inflation is reducing the purchasing power of our money. The same amount will be enabling the investor to buy lesser and lesser goods. 

So how does indexation help us? To understand that, let us first understand what capital gains is. Capital gains are nothing but the increase in the value of an investment over a specific period of time. If a NAV of a fund was Rs. 10 when you invested and is now Rs.15 while you plan to redeem it, that difference of Rs.5 is called capital gains. So we are yielding a capital gain of Rs.5unit when we redeem.  

In the case of debt funds, we arrive at long term capital gains after indexing the purchase price of the investment. When subjected to indexation, it lowers the long-term capital gains tax, which brings down your taxable income. Indexation is the reason why debt funds are looked upon as an excellent fixed-income investment option.

 

How does Indexation Work?

The rate used for inflation in indexation is obtained from the Government’s Cost Inflation Index (CII). The Central Government determines the values of the index and is updated on the Income Tax Departments Website. The data is available from 19981 onwards.

Let us consider the below example to understand how indexation works:

Imagine you invested Rs.1,00,000 in May 2015 in a debt fund of your choice. Today you choose to redeem your money. So you have gained Rs. 1,50,000 on your investment. Since your holding period was beyond 3 years you will not need to be required to pay tax on the entire amount of Rs.1.5 lakhs. You will need to arrive at the indexed cost by using the formula:

ICoA = Original cost of acquisition * (CII of the year of sale/CII of year of purchase)

So the indexed cost will be 1,00,000 (240/301) = 79,734.

So our Capital Gains will now be 1,50,000-79,734 = 70,266.

Using indexation, we have managed to reduce the income subjected to tax, which would be Rs. 14,053.2. 

The benefit of indexation works best when your holding period is longer. For a holding period of 5 years, on average, the long-term capital gains tax on debt funds can come down efficiently. Thus indexation helps us to save tax on Long-Term Capital Gains and increases our earnings.

Remember, indexation is only subjected to Debt Funds & not applicable to Equity Funds.

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