Tax liability in debt mutual funds – how to calculate with indexation?

Debt mutual funds are often preferred by risk-averse investors since these funds primarily invest in fixed-income securities, including money-market instruments, corporate or government bonds, corporate debt securities, etc. These funds are often liquid, low cost, and offer stable returns. 

Since debt funds can provide better capital appreciation, they are preferred over bank fixed deposits.

Debt funds come with the benefit of indexation, which essentially compensates for the risk of inflation and protects investor’s capital. Taxation is an important aspect of any investment and the same goes for debt fund investments. This is because it may reduce the net portion of profits that an investor can have for himself. Therefore, every investor must know the extent of tax liability on any investment. Here, we will specifically discuss the tax liability on debt mutual funds and how an investor can calculate the same with indexation.

How much tax is applicable on debt mutual fund returns?

There are two main forms of returns that can be generated from debt funds, dividend income and capital gains. Both these are taxable as per the Income tax act. 

Taxation on dividend income

Until 31st March 2020, dividend distribution tax was payable by the company declaring dividends and therefore it was tax free in the hands of investors. With the launch of the Finance Act 2020, this rule was modified. Tax on dividend received on or after April 1, 2020 is payable by investors since DDT is no more applicable. Dividend income will have to be added to the net income of an individual investor and taxed as per the income tax slab rate applicable. 

Taxation on capital gains

An investor must pay taxes towards the returns generated through sale of debt fund units. These returns are called capital gains and are further divided into short term and long-term capital gains depending on the holding period.  

Short Term Capital Gains Tax:

If mutual fund units are held by an investor for less than 3 years, short-term capital gains tax is applicable on the profits generated from the sale of such units. The applicable tax rate will be the same as the individual’s income tax slab rate.

Long Term Capital Gains Tax:

For fund units held for more than 3 years, long-term capital gains tax will be applicable on profits made from sale of such units. Further, the tax rate will be different with indexation and without indexation.

• Without indexation, the applicable tax rate will be as per the income tax slab of the investor.
• With indexation, the tax will be 20% of the earnings.

Indexation benefit is unique to debt mutual funds and is not applicable to any other type of mutual funds. It is an investor’s choice whether he/she wants to make use of the indexation benefit.

Additional read – How to save taxes without additional investments?

What is indexation?

Indexation allows an investor to accommodate an adjustment for inflation in the purchase price of an asset. The inflation impact considered in indexation is for the time period between the purchase and sale of an asset. 

Let’s try to better understand this concept with the help of a simple example:

Suppose you invested Rs. 10,000 in a debt mutual fund in 2017 at Rs. 10 NAV. After three years time, in 2020, you decided to redeem the units and the prevailing NAV was Rs. 20. Thus, your investment’s value is Rs. 20,000 with returns or capital gains of Rs. 10,000.

However, the tax will be calculated and payable on the indexed capital gains and not the actual capital gains of Rs. 10,000. Thus, using the formula for indexation:

Index purchase price = (CII of the year of sale of units / CII of the year of purchase) x (Cost of purchase). 

The indexed acquisition cost = Rs.11,066 calculated as (10,000 * 301/272).

Hence, instead of Rs.10,000, the capital gains will now be Rs.8,933, i.e. (Rs.20,000 – Rs.11,066). This calculation shows that you can bring up the cost of acquisition to the current levels using CII and thereby arrive at the indexed returns to further decrease the payable tax.

Here, CII stands for cost inflation index. With inflation, the prices of goods increase over time. This results in a drop in the purchasing power of money. In simple terms, the number of goods that one unit of money can buy decreases. If Rs. 100 can buy two units of goods today, tomorrow it can buy only one unit due to inflation. Cost Inflation Index (CII) is used for estimating the year-on-year price rise of goods/assets due to inflation. 

How does indexation lower the tax liability on debt fund returns?

When you are calculating indexation benefit on the returns from a debt mutual fund investment, you will need the CII for the year of investment and the year of redemption. Here is how you can calculate the indexation benefit to minimise your tax outflow on long-term capital gains tax from debt fund returns.

Suppose you invested Rs. 1 lakh in a debt fund in September 2017 (FY 2017-18). You decide to redeem your investment in September 2021 (FY 2021-22). At redemption, you receive Rs. 1.5 lakhs, making your capital gains Rs. 50,000.

Since you held your investment for more than 3 years, the gain on the investment is called long-term capital gain, and therefore, you can benefit by lowering your tax liability through indexation.

Here is how:

Initial investment in FY 2017-18	Rs. 1 lakh
CII FY 2017-18	272
CII FY 2021-22	317
Purchase price after inflation adjustment	1,00,000 x (317/272) = Rs. 1,16,544
Redemption amount in FY 2021-22	Rs. 1.5 lakhs
Taxable gains post indexation	Rs. 1,50,000 – Rs. 1,16,544 = Rs. 33,455
Taxable gains before indexation	Rs. 50,000

This calculation shows that indexation results in lowered taxable gains. The total tax that you will have to pay on the above-mentioned gains is as below:

	Before indexation	After indexation
Purchase price	Rs. 1,00,000	Rs. 1,00,000
Purchase price adjusted for inflation	Rs. 1,00,000	Rs. 1,16,544
Redemption value	Rs. 1,50,000	Rs. 1,50,000
Capital gains post indexation	Rs. 50,000	Rs. 33,455
Tax payable (@20% tax rate on LTCG)	Rs. 10,000	Rs. 6,691

Conclusion

Before investing in any debt mutual fund, it is important for an investor to perform due diligence while weighing the risk/return profile of the fund against personal investment goals. If invested in debt, mutual funds indexation can benefit investors by reducing the tax liability and thereby allowing better returns. However, to make use of indexation, investors must remain invested in a debt mutual fund for at least 3 years.

FAQs

1. How to invest in debt mutual funds?
   To invest in some of the best debt mutual funds, you can download the Fisdom app on your smartphone. The app has a wide range of mutual funds to cater to different risk and return appetites of investors.

2. Which is better, debt or equity mutual fund?
   Equity mutual funds may offer higher benefits in the long run, however, these also come with higher risk elements. In comparison, debt funds are mainly for short-term investment horizons with predictable and slightly lower returns. These are ideal for risk-averse investors. You can use both of them to meet various investment objectives of yours.

3. Are debt mutual funds better than bank FDs?
   Debt mutual funds are better than bank FDs, since investors can enjoy better liquidity and comparatively higher returns through debt funds.

4. Are debt funds risk free?
   Debt funds are not risk free, as these may have credit and interest rate risk. Also, depending on the securities selected within the portfolio, these may have varying risk elements.

5. Can I invest Rs 100 in mutual funds?
   Certain mutual funds allow SIP investment as low as Rs. 100 to allow investors the option of investing in phases and still enjoying the benefits of mutual fund exposure.

Related Links

• Indexation in Mutual Funds
• Taxation on Mutual Funds
• Know more on Growth and Dividend Option
• ULIPS vs ELSS