Debt Funds: The Tax-efficient Way to Earn Income
The dividend or interest received from debt funds is tax-free in the hands of the investor.
People are keen to save on taxes every year. There is a rush for tax-saving instruments when the financial year ends. But when it comes to investments for creating wealth, people care less or they seem to be oblivious. They may not know much about the tax-efficiency aspects.
Traditional Savings and Tax
Many people invest in fixed deposits (FDs) either in banks or financial companies. Due to declining rates, the interest rate on deposits has reduced considerably. For those looking at fixed income, this may be a good way to start investing money.
People opt for Traditional Saving schemes for the preservation of capital and the guarantee of safe returns. Investors, however, need to introspect whether these “safe” instruments are tax-efficient. The interests these earns are NOT tax-free. It is taxed as per your income tax slab. The interest earned gets clubbed with your other income.
Now, suppose you earn more than 10,000 rupees in a fiscal year as interest. Then the bank or finance company will deduct tax as TDS (tax deducted at source). This is part of the individual’s total tax liability. Subsequently computing the total income, the investor needs to pay the shortfall if the TDS is lower than the net tax liability. On the contrary, if the liability is lower, the investor gets a tax refund.
Debt Mutual Funds are considered better alternative when it comes to tax efficiency. Yes, they do not offer the guarantee of fixed returns, which traditional savings instruments do, because debt funds are subject to interest rate movements.
But debt funds also invest in fixed-return instruments. These may include corporate and bank fixed deposits. They also invest in bonds, debentures, and money market instruments. Debt funds, however, are subject to interest rate movements. When the interest rates rise in the economy, prices of debt instruments fall and vice-versa.
Debt funds are also subject to tax. The dividend or interest received from debt funds is tax-free in the hands of the investor. That is an advantage compared to investment in fixed deposits. Here, the interest is subject to TDS (if it is more than 10,000 rupees). Any income is added to the total income and taxed comparatively at the marginal rate. Tax is payable when the investor sells the units of the fund. This tax is capital gains tax.
In the financial year 2016–17, for example, debt funds were taxed at 20% with indexation where the units are held for more than three years and then sold. This is a long-term capital gain and the tax is applicable only if you sell the units. Here the effective tax rate comes to 23.69% with service tax and cess. Short-term capital gains are applied if you hold the units for less than three years. The structured tax rate of 30% comes effectively to become 35.535%.
So, if invested for the long term, debt funds are more tax-efficient than fixed deposits.
Disclaimer: Subject to current Tax laws. For personal tax implication investors are requested to consult their tax advisors before investing.
Indexation and Its Benefits
The value of money is never constant. It changes with time. Something bought 10 years ago would not cost the same if purchased five years later.
The Income Tax Department recognises and allows for the erosion in the value of money. This way, investors can benefit when they sell an asset. They do not have to pay undue capital gains tax because the value of money has depreciated.
The cost of acquisition or the purchase price of the asset (or security in this case) has to be adjusted accordingly. This is called indexation. The Income Tax Department comes out with a cost inflation index (CII) every year. This index is used to adjust the purchase price. (http://www.incometaxindia.gov.in/Pages/utilities/Cost-Inflation-Index.aspx)
Considering an example, Suppose Ram invested 1,000 rupees in a debt mutual fund in January 2010 at 10 rupees per unit and he decides to redeem it in June 2014. At the time, the net asset value (NAV) is 20 rupees per unit. The capital gains, in this case, are not 1,000 rupees (i.e. Rs 2,000 – Rs1,000) but indexation would apply here to adjust for inflation.
The CII for 2009–10 (year of investment) is Rs 632.
The CII for 2014–15 (year of sale) is Rs 1,024.
The indexed cost of purchase in 2014–15 is 1,000 X (1,024/632) = 1,620 (rounding off). After indexation, the capital gains work out to Rs 380 (Rs 2,000 – Rs 1,620).
The tax on this at 20% works out to Rs 76.
Disclaimer: The above example is only for illustration purposes, purely to explain the concept of the indexation. For more details please consult your Tax Advisor
Benefits of Investing in Debt Mutual Funds
Tax efficiency is one of the prime advantages of investing in debt mutual funds. In comparison, most other debt products are subject to tax at an individual’s slab rates. Another reason for investment in debt funds is the effect of interest rates. Most debt funds have a good proportion of government securities too.
Investors need to go through the portfolios of debt funds to understand the types of instruments and securities in which the fund managers have invested their money.
Suppose inflation rates in the economy are low and interest rates are on a downward trend. This helps in the capital appreciation of debt fund units. That is possible because the prices of government securities rise. Of course, when interest rates rise, the reverse also happens. Then debt funds lose in value.
That is why fund managers usually manage their portfolios in a specific way. They ensure that there is a balanced mix of other fixed-return instruments. These may include debentures, bonds, and term deposits. This reduces the capital erosion.
Systematic Investment Plans (SIPs) present the best way to invest in debt income funds. SIPs allow one to make regular investments over the long term. During periods of high-interest rates, investors may get more units for a fixed amount. That is because the value of the units drops. And when the interest rates are low, they enjoy the benefit of capital appreciation.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.
This is a partnered post.