Given the volatility the markets have been witnessing last year, many investors lost hope in equities as they had to face major losses.
During these tumultuous times, people also shifted from being risk takers to being risk averse; meaning quitting equities and switching their investments towards debt instruments.
Therefore, in this article we will describe what debt funds are and their tax implications.
Tax Implication on Debt Funds
To understand the tax implications in case of debt funds, let us divide debt funds into two categories:
- Investments for less than three years;
- Investments for more than three years
Investments Less Than Three Years
Firstly, for investments for less than three years, the interest income is added to your total income and taxed as per your tax slab.
Let’s understand this with an example. Say your income for FY 19 before adding the interest income on debt instruments is INR 5 lakhs, suppose you earn INR 50,000 as interest in debt funds, the total sum comes out to be INR 5.5 lakhs.
The tax slabs for the current financial year has been stated below:
|Income Slab||Tax Rate|
|Less than 2.5 lakhs||Nil|
|2,50,001 – 5,00,000||5%|
|5,00,001 – 10,00,000||20%|
|More than 10 lakhs||30%|
Note: The above tax slab is applicable for FY’19
Based on the above table, the total tax is calculated as INR 32,500. Please note that the additional 50,000 income that we had from investing in debt instruments is taxed at 20% as the income is above INR 5 lakhs (The 50,000 interest received can be termed as short term capital gains).
Investments More Than Three Years
In the case of investments made for more than three years, the interest proceeds are taxed at the rate of 20 percent with the benefit of indexation.
Indexation basically adjusts your income payment through a price index. It is done to maintain the purchasing price of the public after inflation, thereby, helping you to lower tax liability.
Let’s take an example to understand this concept. Say you have invested INR 10,000 in debt funds in FY 2014-15. The value of investment in FY 2017-18 stands at INR 20,000. To arrive at the capital gains as per tax laws, you follow the form:
ICoA = Original cost of acquisition * (CII of year of sale/CII of year of purchase);
Where ICoA is the Indexed Cost of Acquisition; and
CII is the Cost Inflation Index which is brought out by the Finance Ministry every year
So the ICoA in our case will be:-
10,000 * 272/240 = INR 11,333/-
Therefore, the cost of acquisition which was INR 10,000 comes out to be INR 11,333 thereby limiting capital gains from 10,000 (20,000-10,000) to 8,667 (20,000-11,333). Hence we need to pay less tax.
Note: In case you are investing in a dividend plan, surplus is paid out as dividends which is then taxed as dividend distribution tax at an efficient rate of 29.12 percent.
Once this dividend is paid out, the NAV of the fund falls to the extent of the payout. Due to this fall, during times of redemption, the value of the fund might not be the same as the initial investment.
Hence, sometimes capital gains are not prevalent in case of dividend options. They are more applicable in case of growth options wherein the value that is earned gets accumulated and added to the NAV of our fund.
What Are Debt Funds
Debt funds are those funds that invest in different securities across a wide credit spectrum.
A high credit rated instrument will fetch us a lesser interest rate as the risk involved with these securities is less. Opposite is the case with a low rated security.
However, most debt funds try to allocate a higher portion of its corpus to high rated securities as they are less volatile and fetch regular repayment of interest and principal.
The different kind of securities that debt funds invest in, consists of corporate bonds, government securities, treasury bills, commercial papers and other money market instruments.
If an organization is issuing debt instruments, it is simply asking for a loan from the investor. The basic reason behind investing in a debt fund is to earn interest income.
In case of these funds, the issuer pre decides on the interest rate and the period of maturity.
Why Should You Invest in a Debt Fund?
As debt funds try to diversify by investing the corpus in various instruments, they provide reasonable returns at lower risk. Therefore, if you are looking to put your money in a safe instrument, this will be the right investment for you.
The time frame can be decided based on your goals. Debt funds are preferably best for short-term investments.
However, before putting your hard earned money you should consider aspects such as risk, returns, cost, the investment horizon, future goals as well as tax implications.
Debt funds are suitable investments if you are a conservative investor.
From amongst these parameters, tax implication is one of the major ones. Hence understanding this key concept will help you throughout.
Disclaimer: The views expressed in this post are that of the author and not those of Groww