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 under capital appreciation as well as annual dividend earnings, which are also adjusted for indexation, unlike FDs.

Due to a lower risk associated with debt instruments, and thereby, higher chances of earning profits, tax rates imposed on debt funds tend to be higher than ones imposed on equity instruments.

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 security was in possession of the investor for less than 3 years, then, the total profit earned from the transfer is taxable, but the rate depends on the annual income of the investor.

However, long term capital gains earned from the sale of debt securities after a minimum ownership time frame of 3 years is charged according to the annual income of the investor, when adjustments for indexation are not made, and 20%, when such amendments are completed.

Short term capital gains have a predetermined range of 10%-37%, depending upon the income slab in which a consumer belongs.

                                         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  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?

Indexation adjusts the total nominal value of returns earned minus the inflation, thereby allowing investors to retain the real value of their gains earned. This enables investors to ensure the amount of total purchasing power obtained is not eroded as a result of the prevailing inflation rate in the country.

Indexation allows various economic factors of production to take advantage of the market inflation rate by boosting its total production, thereby increasing the total GDP of the country, without its adverse effects impacting consumers.

Read More : Indexation In Mutual Funds : Meaning, benefits, and more

Since indexation reflects the real value of the gains made by an investor, which is lower than the nominal value, the effective payable tax on debt funds also reduces.

 How To Calculate The Adjusted Value After Indexation?

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. 4 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 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 = Rs. 1,16,666.67 – Rs. 1,00,000 =Rs. 16,666.67.

This value is subjected to a tax deduction of at 20% of its value.

Tax payable = 20/100 * 16,666.67  = Rs. 3333.334.

As we can see, indexation adjusted tax rate only attracts a payment of Rs. 3333.334, while, tax rate if inflation is not taken into account deducts Rs. 8,000 from your total income. Thus a tax on debt funds is usually higher if not adjusted for the prevalent inflation rate in the market.

Just by looking at the interest rate, it might seem like a better option to not take inflation into account. Only tax rate of 10% is levied, as opposed to 20% in case of adjustments for indexation are made. However, the actual scenario is much more complex, wherein indexing your earnings allows you to save considerably.

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 maximizing the total returns earned.