Debt Mutual Funds: Taxation, Returns and Benefits (2024)

What are Debt Mutual Funds?

Bonds, debentures, and other fixed income securities, as well as other debt instruments make up the majority of the investments made by Debt Mutual Funds. Before going into the changes understanding debt mutual funds and their current tax structure is crucial. Conservative investors favour these assets as investments since they often produce returns in the form of interest or Capital Growth.

A specified mutual fund is a mutual fund that invests less than 35% of it’s proceed in equity shares of Domestic companies for taxation purposes.

How Investors Earn Returns in Mutual Funds?

Dividends and capital gains are the two return options offered by mutual funds. If there are any company profits, they are used to pay dividends. When businesses have extra cash on hand, they may choose to distribute it to investors as dividends. In proportion to the number of units they own in mutual funds, investors earn dividends.

If an investor sells a security they own for more money than they paid for it, they will have realized a capital gain. In simple words, capital gains are realized as a result of an increase in the price of mutual fund units. In the hands of investors in mutual funds, dividends and capital gains both are taxed.

What is Tax on Debt Mutual Funds?

Mutual fund investment profits are taxable as “capital gains” under the Income Tax Act, 1961. Therefore, Investors should be completely aware of how their earnings will be taxed before investing in mutual funds. In some circ*mstances, they can also get tax deductions.

What are the Factors to Determine Tax on Debt Mutual Funds?

Identifying the variables that affect mutual fund taxation can help to further explain it. The following are the main variables that have an impact on mutual fund taxes:

• Fund Types: There are two different sorts of mutual funds that are taxed. They are mutual funds that focus on equity and debt, respectively.
• Dividend: A portion of the profit that mutual fund companies provide to investors is known as a dividend.
• Capital Gains: Capital gains are profits made when investors sell their capital assets for more money than they originally invested.
• Holding Period of Investor: The interval between the acquisition and sale dates of mutual fund units. According to Income Tax Act, 1961 if Investors keep their investment for a long time, they will only have to pay a little amount of tax. The holding term so affects the tax rate that must be paid on your capital gains. Investors Tax Liability decreases with the length of their holding period.

Taxation of Debt Mutual Funds before 1^st April 2023

The holding period rule previously governed the taxation of Debt Mutual Funds:

Short- Term Capital Gain (STCG): The profit are referred to as short- term capital gains if the debt mutual fund unit is sold within 36 months or three years of the purchase. Investors other income was increased by these short term capital gains, which were then taxed at slab rates.

Long Term Capital Gain (LTCG): The profit are referred to as Long- term capital gains if the debt mutual fund unit is sold after 36 months or three years. These long term capital gains were subject to 20% indexation-advantaged taxation. The term “indexation benefit” refers to the process of adjusting investment gains for inflation.

Taxation on Debt Mutual Funds After 1^st April 2023

The indexation benefit on debt mutual funds was Scrapped by an amendment to Finance Bill 2023. They are now subject to investor-slab rates of taxation. With these adjustments, the taxes of certain mutual funds will be equal to that of fixed deposits. Continue reading to see how this decision may affect you and the taxes of debt mutual funds.

When computing long-term capital gains on Specified Mutual Funds (mutual funds that invest less than 35% of their proceeds in domestic company equity shares), indexation benefits will not be accessible. Mutual funds that invest in debt will now be taxed at the corresponding slab rates.

A Specified Mutual Fund would no longer receive an indexation benefit when calculating long-term capital gains (LTCG), according to changes made in the Budget 2023. Debt mutual funds will therefore now be taxed at the appropriate slab rates.

Additionally, LTCG on gold mutual funds, hybrid mutual funds, international equity mutual funds, and funds of funds will not be eligible for indexation benefits. In order to minimise Assets Under Management (AUM) fees/charges, investors may decide to invest directly in debt securities rather than debt mutual funds. As a result, mutual fund houses are expected to suffer. Due to a potential increase in the tax burden on the profits, the move may also affect how appealing these mutual funds are as an investment alternative.

Are Fixed Deposits (FDs) better than Debt Mutual Funds?

Debt funds can still be an excellent tax-saving investment option despite recent developments that suggest they are now similar to fixed deposits for a number of convincing reasons:

Debt mutual funds, for example, are not taxed on the earnings until the investments are sold, unlike fixed-deposit investments. You may be able to postpone paying taxes as a result.

The ability to withdraw money without incurring fees is provided by flexi FDs. The early withdrawal fee can be due if you choose ordinary FDs, nevertheless. In contrast, after a set amount of time, debt funds don’t charge exit loads. Debt funds, as opposed to bank FDs, can offer more liquidity and be more affordable.

Compared to fixed deposits, debt funds usually offer better returns.

The debt mutual fund profits are classified as Capital Gains, while Fixed Deposits are classified as Income from Other Sources. This indicates that losses incurred by debt mutual funds may be carried forward and offset against Gains.

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The above article has been written by Mr. Yash Bagadi (CA Inter Qualified) and reviewed by Mr. Suyash Tripathi (Chartered Accountant) and they can be reached [email protected] and [email protected].