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Taxation of Debt Funds

IndianMoney.com Research Team | Updated On Tuesday, March 12,2019, 12:10 PM

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Taxation of Debt Funds

 

 

Debt Fund is a type of mutual fund which invests your money in fixed income securities like corporate bonds, government bonds, NCDs, money market instruments and so on. Debt funds are much safer than equity as they invest in risk-free government bonds and highly reputed AAA corporate bonds.

Government bonds are risk-free. Corporate bonds have an element of risk. Check rating of corporate bond, before making an investment.

Why invest in Debt Fund?

 Invest in a debt fund to earn interest income and capital appreciation. Debt funds invest in securities based on credit rating. The credit rating tells if the issuer will default on interest payments. The debt fund manager makes sure your investment is in high quality credit instruments. This is to be sure; the debt security will repay principal and interest obligations.

Want to know more on debt funds? We at IndianMoney.com will make it easy for you. Just give us a missed call on 022 6181 6111 to explore our unique Free Advisory Service. IndianMoney.com is not a seller of any financial products. We only provide FREE financial advice/education to ensure that you are not misguided while buying any kind of financial products.

SEE ALSIO:  Why Invest Debt Fund

 Taxation of Debt Funds

Returns on a debt fund: Debt fund is a type of mutual fund in which your and other investor’s money is pooled and invested in highly rated fixed income securities. Debt funds are managed by professional fund managers. Debt funds have low expense ratio. They give higher returns vis-à-vis fixed deposits.

Debt funds are almost as safe as fixed deposits. Invest in debt funds in-line with financial goals. Choose a debt fund with time horizon in-line with financial goals.

Debt funds can be an inflation beater. Even though they have a measure of risk, they give higher returns than FDs. Let’s say you have invested in fixed deposits at 6.5% interest. The inflation is 3.5%. The inflation adjusted returns (real rate of return) is just 3%. Debt funds deliver better results. If you feel the markets are positive, invest in debt funds over fixed deposits.

Tax on Debt Funds:

If you stay invested in debt funds for less than 3 years, the profits/gains are called short-term capital gains. If you stay invested in debt funds for more than 3 years, the profits/gains are called long-term capital gains.

Long-term capital gains or LTCG on debt funds are taxed at 20% after indexation. With indexation, the effects of inflation are taken into consideration when calculating tax on capital gains.

Example for calculating tax on STCG on debt funds:

Ravi an IT executive earns Rs 9 Lakhs a year. Ravi falls in the 20% income tax bracket. Ravi had invested Rs 1 Lakh in debt funds for a period of 2 years. How will Ravi’s gains be taxed?

Ravi stayed invested in debt funds for a period of 2 years. Any gains made are short-term capital gains or STCG. STCG is added to taxable income and taxed as per income tax slabs.

Let’s say Ravi earned Rs 10,000 on debt funds. This is short term capital gain. It’s added to his taxable salary and taxed as per income tax slab. (This is 20% income tax slab).

Let’s say Ravi invested Rs 1 Lakh in debt funds in February 2013. He withdrew Rs 1.5 Lakhs in May 2016. How is the debt funds taxed?

CII chart:

Financial Year

Cost Inflation Index (CII)

2018-19

280

2017-18

272

2016-17

264

2015-16

254

2014-15

240

2013-14

220

2012-13

200

2011-12

184

2010-11

167

2009-10

148

2008-09

137

2007-08

129

2006-07

122

2005-06

117

2004-05

113

2003-04

109

2002-03

105

2001-02

100

Anytime before 1st April 2001

100

CII for the year of purchase = 200 (Take this from the chart for 2012-13).

CII for the year of sale = 264 (Take this from the chart for 2016-17).

Cost after indexing = Cost before indexing * CII for sale year / CII for purchase year.

Cost after indexing = 1,00,000 * 264/200 = Rs 1,32,000.

Long Term Capital Gain = Sale Price – Cost after indexation.

Long Term Capital Gain = Rs 1,50,000 – Rs 1,32,000 = Rs 18,000.

Lets calculate LTCG tax @20% = Rs 18,[email protected] 20% = Rs 3,600.

Debt Funds for Short Term:

Short-term debt fund is a mutual fund scheme for investments of 1-3 years. Debt funds enjoy stable returns, maintain a balanced portfolio and meet financial goals. Debt funds can give returns of 8-9% a year, which is more than FDs. However, there are shortcomings.

Credit Risk: Check the rating of the debt fund before investing. AAA rated short term debt is quite safe. Lower rated short term debt funds offer higher returns, but have higher credit risk. (This is a higher chance of a default on principal and interest).

Interest: Interest rates in the market affect returns on short-term debt funds. If interest rates rise in the economy, short-term debt fund interest rates increase. Interest is inversely related to price and subsequently, the price of the mutual fund falls. On the other hand if interest rates fall in the market, short-term debt fund interest rates fall. The price of short-term debt fund rises giving better returns.

Inflation: Inflation measured by CPI index eats up returns on short-term debt funds.

SEE ALSO:  Debt Funds for Short Term

Liquidity Risk: Check for the options for an exit from short-term debt.

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