Debt Mutual Funds Taxation: A Detailed Overview
Smart investment ensures financial security and peace of mind. However, it depends on choosing the right instruments that promise steady income, growth, and minimal risks. Debt mutual funds are a dependable option for people looking for a consistent flow of income. Nonetheless, the taxation of mutual funds in debt has changed, with notable revisions as recently as 2023. In this article, we will examine the taxes of debt mutual funds and how these modifications impact investors and their financial choices in the long run.
Table of Contents
What are Debt Mutual Funds?
Understanding debt mutual funds and their current tax structure is crucial before talking about the adjustments. Investment vehicles known as debt mutual funds primarily allocate their capital to fixed-income securities, such as bonds, treasury bills, commercial papers, debentures, and other debt instruments. Conservative investors favour these securities because they often yield returns in the form of interest or capital appreciation. A mutual fund that allocates less than 35% of its profits to domestic company equity shares is considered a specified mutual fund.
Debt Mutual Funds Taxation After 1 April 2023
A Specified Mutual Fund would no longer benefit from indexation when calculating long-term capital gains (LTCG), according to changes made in the Budget 2023. Debt mutual funds will be subject to the relevant slab rates of taxation. Additionally, LTCG will not be eligible for indexation benefits on funds of funds (FOF), international equity mutual funds, hybrid mutual funds, or gold mutual funds. To minimize AUM fees and costs, investors may choose to invest directly in debt securities rather than debt mutual funds, which would have a negative impact on mutual fund houses. Due to the potential increase in the tax burden on the profits, the move may also affect how appealing these mutual funds are as an investment alternative.
Debt Mutual Funds Taxation Before 1 April 2023
Previously, the holding term regulation controlled how debt mutual funds were taxed:
Short-Term Capital Gains: Gains are referred to as short-term capital gains (STCG) if the debt mutual fund unit is sold within 36 months (three years) of purchase. Slab rates apply to certain STCGs' taxes.
Long-Term Capital Gain: The gains were referred to as long-term capital gains (LTCG) if they were sold after 36 months. With an indexation benefit, these long-term capital gains were subject to 20% taxation. The indexation advantage indicates that investors' gains were modified to account for inflation.
Factors Affecting Debt Mutual Funds Taxation
The primary factors influencing mutual fund taxation are listed below:
Fund Types: The type of mutual fund subject to taxation determines this. There is no indexation benefit if the investment is a short-term debt fund.
Capital Gains: Profits from the sale of capital assets at a price higher than the purchase price are known as capital gains.
Investor Holding Period: The investor's holding period is the interval of time between the date of capital asset acquisition and the date of sale. An investor will pay less in taxes if they keep their investments for a long time.
Dividend: A dividend is a percentage or part of the profit that mutual fund firms give to their investors.
Impact of Change in Income Tax Rules on Debt Mutual Funds Taxation
Before and after the revisions, let's look at the tax flow on debt funds. During FY 2020–21, Mr. X invested Rs. 10,000 in a debt mutual fund. Three years later, in FY 2023–24, he sold the assets for a sale price of Rs. 20,00,000, earning Rs. 10,00,000 in capital appreciation.
Particulars | Financial Year | Cost Inflation Index (CII) | Amount |
Initial investment | 2020-21 | 301 | Rs. 10,00,000 |
Sale | 2023-24 | 348 | Rs. 20,00,000 |
Less: Indexed Cost of Investment | - | (10,00,000*348/301) | Rs. 11,56,146 |
Long-term capital gain | - | (20,00,000-11,56,146) | Rs. 8,43,854 |
Tax Payable on LTCG | - | Tax @ 20% | 1,68,770 |
Tax Liability after the changes (from FY 2023-24):
Particulars | Financial Year | Cost Inflation Index (CII) | Amount |
Sale | 2026-27 | - | Rs. 20,00,000 |
Less: Investment Made | 2023-24 | - | Rs. 10,00,000 |
Short-term capital gain | - | - | Rs. 10,00,000 |
Tax Payable | - tax bracket 30% - tax bracket 20% - tax bracket 10% | - | Rs. 3,00,000 Rs. 2,00,000 Rs. 1,00,000 |
LTCG tax before and after the recent changes in debt fund taxation:
Tax Bracket | Before debt fund taxation rule amendments | After debt fund taxation rule amendments |
30% | 1,68,770 | 3,00,000 |
20% | 1,68,770 | 2,00,000 |
10% | 1,68,770 | 1,00,000 |
People in the 20%–30% tax bracket will suffer as a result of the recent changes to debt fund taxation, as demonstrated in the example above.
Impact of Debt Mutual Fund Taxation Changes on Investors
Investors will be impacted significantly by the recent amendments that eliminated the indexation benefit on long-term capital gains since they would have to pay more taxes. Nevertheless, there are several advantages to investing in debt mutual funds.
Capital gains tax only applies when a capital asset is sold or transferred. This means the investor is exempt from paying taxes while the investment is held.
Investors can offset capital losses with debt-mutual fund returns, unlike with FDs. It is also possible to carry over the capital losses to subsequent years.
Also, any LTCG or STCG within the same fiscal year may be used to offset the short-term capital loss.
Although the recent adjustments announced in the budget 2023 have made debt mutual funds more taxable, it's crucial to realize that there are still many alternative options to reduce capital gains taxes.
LTCG and STCG Rates in 2023-24 and 2024-25
Changes to the long-term and short-term capital gains tax rates and holding periods were implemented in the Budget 2024, released on July 23, 2024. Before the 2024 budget, certain mutual funds with debt levels greater than 65% were subject to investor slab taxation rates if the holding duration was longer than 36 months. This holding time has been shortened to 24 months following the Budget 2024 modification. The capital gains tax rates for FY 23–24 and FY 24–25 are compared in the table below.
Investment Type | Before | - | - | After | - | - |
- | Period of holding | Short Term | Long Term | Period of holding | Short Term | Long Term |
Equity-oriented MF units | > 12 months | 15.00% | 10.00% | > 12 months | 20.00% | 12.50% |
Specified Mutual funds with more than 65% in debt | > 36 months | Slab rate | Slab rate | > 24 months | Slab rate | Slab rate |
Equity Fund of Funds | > 36 months | Slab rate | Slab rate | > 24 months | Slab rate | 12.5% |
Overseas Fund of Funds | > 36 months | Slab rate | Slab rate | > 24 months | Slab rate | 12.5% |
Gold Mutual Funds | > 36 months | Slab rate | Slab rate | > 24 months | Slab rate | 12.5% |
Fixed Deposits And Mutual Funds Taxation: A Comparison
The following table shows a comprehensive comparison between FDs and mutual fund taxation:
Particulars | Fixed Deposits | Equity Mutual Funds (Equity: > 65% Debt: < 35%) | Debt Mutual Funds (Equity: <35% Debt: > 65%) | - |
- | - | - | Old Rule | New Rule |
Fund types | FDs |
|
| - |
Taxable Amount | Interest | Capital Appreciation | Capital Appreciation | Capital Appreciation |
Taxability Period | Per year on an accrual basis | When mutual fund units are sold/redeemed | When mutual fund units are sold/redeemed | When mutual fund units are sold/redeemed |
Holding Period | - | 12 months | 36 months | - |
Tax Rate | Slab rates | - STCG: Slab rates - LTCG: 10% (on gains exceeding Rs 1 lakh) | - STCG: Slab rate - LTCG: 20% (with indexation benefit) | - Deemed to be STCG: Slab rate |
Set off/Carry Forward of Losses | Not Allowed | Allowed | Allowed | Allowed |
Fixed Deposits or Mutual Funds: Which Are Better?
Even while recent events indicate that debt funds are now on a level with fixed deposits, there are still a number of strong arguments for why debt funds can be an excellent way to save money on investments.
In contrast to fixed deposits, debt mutual funds are only taxed upon the sale of the investments. It can assist you in postponing taxes.
With flexi FDs, you can take money out whenever you choose without incurring penalties. However, you might be required to pay the early withdrawal penalty if you use standard FDs. On the other hand, debt funds don't charge exit fees after a predetermined amount of time. As a result, debt funds offer more liquidity and may be more affordable than bank FDs.
Returns on debt funds are generally higher than those on fixed deposits.
Capital gains are the profits from debt mutual funds, whereas "income from other sources" is the classification for fixed deposits. It implies that losses incurred by debt mutual funds can be optimized and used to offset gains.
Conclusion
The modification to the long-term capital gains tax regulations for debt mutual funds will affect investors who made investments to profit from indexation in the past. Furthermore, since indexation assisted investors in adjusting the purchase price, which has since been eliminated, the shift in tax structure from 20% with indexation to 12.5% without indexation may result in a tax obligation. However, depending on the year of purchase and the returns received, the effect could vary from case to case. Therefore, to comprehend the tax implications, taxpayers should verify the transaction date of the debt mutual fund purchase.
FAQ
Q1. Where to show debt mutual fund income in an income tax return?
The revenue from the debt mutual fund is added to the total income under the heading of "income from other sources" and regarded as the investor's income. The ITR-1 must include this revenue under "income from other sources."
Q2. Where to show a short-term capital gain on debt mutual funds in an income tax return?
In the "Capital Gains" section of your ITR, you must include your income from STCG on debt mutual funds. Provide the holding time, the amount earned, and any appropriate taxes based on your income tax bracket when you specify the profits under "Short-Term Capital Gains."
Q3. What are STCG and LTCG on debt mutual funds?
The duration of holding determines how debt mutual funds are taxed. The investor's income slab determines short-term capital gains (STCG) from holdings under three years. After three years, long-term capital gains (LTCG) are subject to 20% tax with indexation benefits.
Q4. What is the indexation benefit on debt mutual funds?
A debt mutual fund's "indexation benefit" is the ability to use the Cost Inflation Index (CII) to adjust the purchase price of a debt fund unit based on inflation. It effectively lowers the taxable capital gain and reduces tax liability when you sell the investment. However, as of April 1, 2023, this benefit is no longer available for debt mutual funds purchased on or after that date, meaning that all capital gains must be taxable as short-term gains according to your income tax slab rate.
Q5. Are debt funds tax-exempt?
Debt funds are not exempt from taxes; they are only taxable when the capital asset is sold or transferred.
Q6. Is TDS deducted for debt mutual funds?
No, debt mutual funds are not subject to TDS deductions. Once the interest accumulates, tax is due on FDs throughout the year. In contrast, tax obligations for debt mutual funds only materialize upon the sale or transfer of the asset or mutual fund.
Q7. Are indexation benefits removed from debt mutual funds?
Any gains from debt mutual funds bought after April 1, 2023, regardless of the holding period, will be considered short-term capital gains and subject to slab rate taxation. Debt mutual funds (non-equity mutual funds) bought before April 1, 2023, will still be subject to the previous regulation, and if held for more than three years, you will receive a special rate of 20%.
Q8. Am I liable to pay tax on the Systematic Withdrawal Plan (SWP)?
Yes, mutual fund redemption is a part of SWP. You will be subject to capital gain tax if the units are sold for more money.
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