Debt mutual funds are becoming the popular choice among investors looking for alternative low-risk options other than bank fixed deposits. The main advantage of these funds is the ability to make profits with the increase in the value of the investment: this phenomenon is also known as capital appreciation.
Another main benefit of debt funds is that it cushions you against inflation risk and this phenomenon is known as indexation benefit. Indexation benefit calculation allows you to inflate your purchase price. This compensates you for inflation. So when you sell your fund on a later date, indexation benefit will allow you to inflate your purchase price on that date to reflect the true value of your purchase and you may end up paying lower taxes on the difference between your purchase and sale price. Indexation in mutual funds is allowed only in the debt fund category.
In this article
How Much Is The Tax Liability on Debt Mutual Fund Earnings?
All forms of income through debt funds are subject to taxation as per the Income Tax Act of 1963. Tax liability on dividend returns of such funds is not levied on investors directly. Instead, they are paid by the asset management company themselves. As of 2019, 29.12% dividend distribution tax is payable on total earnings of debt mutual funds, where 25% is allocated towards tax payments, 12% on surcharge payments, and 4% cess charges.
However, profits made through the purchase and sale of NAV units in the stock market, on the other hand, are chargeable for tax purposes. If the debt fund was sold before three years, then, the total profit earned from the transfer is taxable, but the rate depends on the annual income of the investor.
Short term capital gains have a predetermined range of 10%-37%, depending upon the income slab in which a consumer belongs.
However if the debt fund is held for more than three years, the gains are considered long term capital gains and the tax is levied in two ways:
- With indexation benefits: 20%
- Without indexation benefits: according to the income of the investor
Tax on Capital Gains on debt mutual funds
|Type of Gain||Eligibility criteria||Tax rate|
|Short term capital gains||Security was held by the investor for less than 3 years||As per the annual income of an individual|
|Long term capital gains||A possession time period of the NAV units of debt mutual funds should be more than three years||Depends upon the income of the investor (without indexation)|
20% (with indexation)
However, in case an investor incurs capital loss during the sale of NAV units of debt mutual funds, it is exempted from income tax calculations for the respective financial year.
What is Indexation?
Let’s understand indexation in mutual funds in a bit more detail. Indexation is basically the process by which you account for inflation in your debt fund gains so that you pay fewer taxes.
We all know the value of rupee goes down over a couple of years and is the best way to look at indexation. While in May 2018 the value for one dollar was around Rs 67, now the value for one dollar is around Rs 76 levels. This 13.4% jump from 67 to 76 is an embodiment of inflation and how it has cropped our purchasing power.
Indexation benefit seeks to give you returns over and above this inflation. If you inflate your purchase price according to the ongoing inflation rate, the gap between your sale and purchase price will reduce and you will pay lower taxes.
Indexation calculation for debt funds
The total adjustment of capital gains depends on the cost inflation index (CII) declared by the Central Board of Direct Taxes (CBDT) every year. The real value of profits can be determined by using the following indexation formula –
Actual value after indexation = original amount * (CII of the current year/CII of the purchasing year.)
Let us demonstrate this with an example. Mr. X had invested Rs. 1 Lakh in a debt mutual fund in 2014. Four years later, he decides to redeem his investment at Rs. 1.8 Lakh in 2018, thereby realizing a profit of Rs. 80,000.
However, this income is subjected to long term capital gains tax on debt funds.
If adjustments for indexation are not made, let us assume that a 10% tax is deductible, as per the total annual income of the investor. In such circumstances, the total tax payable would amount to –
Tax = tax rate * total profit
= 10/100* 80,000
= Rs. 8,000
Therefore, a total of Rs. 8,000 would be deducted from the total profits of the investor, leaving him with Rs. 72,000.
The situation is different if the persisting inflation rate in the country is taken into account. In 2014, the CII of India was 240. In 2018, the value increased to 280.
Thereby, the nominal value of investment realized can be determined by the indexation formula –
Inflation-indexed worth = 1,00,000 * (280/240) = Rs. 1,16,666.67.
Therefore, total gains realised = Redemption Value-Indexed Cost
Rs (1,80,000-1,16,666.667)= Rs 63,333.33
This value is subjected to a tax deduction of 20% of its value.
Tax payable = 20/100 * 63,333 = Rs. 12,666.67
Total realisable profit= Redemption value-Tax payable
Rs (80,000-12,666.67)= Rs 67,333.33
As we can see in this indexation calculation for debt funds, the indexation adjusted tax rate gives you a profit of Rs 67,333.33 while without indexation, you would be getting a profit of Rs 72,000.
In the example we observed, if the same person was in a higher income tax bracket and would be attracting income tax of say 15-20%, the profit he would earn from his debt fund without indexation can vary and may or may not be lower than the indexed profit. Hence it completely depends on which income tax bracket you are in and how much you earn.
Final words: Should you go for debt fund indexation benefit?
You should do the due diligence in doing the indexation benefit calculation and checking which system suits you best. You may never know what you are missing out on. Like I mentioned above, it depends on various factors, one of them being your income level and tax bracket.
Adjustments for indexation are not made in conventional savings schemes, such as fixed deposits. Thus, tax payable on those earnings is considerably higher, making it a less attractive option for investors countrywide.
You can choose between the two options available while determining your total tax liability. Using an indexation calculator, the total tax payable can be determined when the inflation rate is considered, while tax rates without adjustments can be calculated through standard calculators.
Comparing the total tax liability and profits under both these situations, you can easily decide under which method you want to pay your taxes, thereby maximising the total returns earned.