Debt Mutual Funds are the next favourite investment options for those investors who prefer low risk and steady returns after fixed deposits and other small saving schemes etc. This is of course at the first preference of any intelligent investor who looks at better tax adjusted yield which has high potentiality to beat inflation as well. When I say better tax adjusted yield, you got it right; Debt Mutual Funds returns are taxed whether the gains are from short term or long term holding. The short term gain or Short Term Capital Gains (STCG) arises when the returns from any debt mutual funds are realised within 12 months from the date of initial investment. In case where such gains from debt mutual funds are realised on or after 12 months from the date of holding start date, it considered to be Long Term capital gains (LTCG).
Tax on Short Term Capital Gains (STCG) from Debt Mutual Funds
Any gains realised out of debt fund where the period of holding is less than 365 days, is classified as short term capital gains (STCG) and these are taxed as per the income tax slab of the individual based on his total income. This indicates that you need to add these gains to your taxable income and pay the income tax. For e.g. you purchased ABC Debt Mutual Fund (assume growth option) in January 3, 2013 for Rs. 10,00,000 and sold on August 9, 2013 for Rs. 10,77,500. Since the duration of holding is only 220 days i.e. less than 365 days, the returns of Rs. 77,500 added to your taxable income and tax needs to be paid based on the tax slab.
Suppose you fall under the tax slab of 30% (plus 3% cess), then you are liable to pay straight 30.90% tax on such gains. Finally your net gain will be Rs. 53,552.50 i.e. [Rs. 77,500 – (30.90% of Rs. 77,500)].
Tax on Long Term Capital Gains (LTCG) from Debt Mutual Funds
Any gains realised out of debt funds where the period of holding is more than 365 days, is classified as long term capital gains (LTCG). Taxation of long term gains from debt funds are little complex, but not difficult to understand. Here investors can actually decide how to present such gains so that his tax liability will be reduced. Long Term Capital Gains from debt funds are taxed 10% (plus 3% cess) without indexation or 20% (plus 3% cess) with indexation whichever is less.
If you do not know, Indexation refers adjusting the price of an asset for inflation i.e. the cost price of an asset is adjusted so that any increase in price of the asset due to inflation is factored in. Inflation is measured every financial year and the value is known in the Cost Inflation Index (CII). Through indexation, one can bring the cost of investment in the debt fund to the current value, after factoring the rise in price (inflation). CII is declared by the Government every year. Let us understand these jargons with simple example below.
Example: Suppose you purchased ABC Debt Mutual Fund (assume growth option) in December 3, 2011 for Rs 10,00,000 and sold on August 9, 2013 for Rs 11,50,000. Since the duration of holding here is 615 days which greater than 365 days, the profit will be considered as LTCG and calculation goes as below;
You might want to read: Cost Inflation Index (CII) since 1981
As you can see clearly above that the LTCG without indexing the cost of investment comes Rs. 1,50,000 that means you are liable to pay 10.30% tax straight which brings you a tax liability of Rs. 15,450 and reduces your net gains to Rs. 1,34,550 i.e. [Rs. 1,50,000 – (10.30% of Rs. 1,50,000)]. But if you consider indexed cost of investment on the redemption date then your gain amount turns to loss of Rs. 46,178. This shows that you may not have to pay any tax since you incurred loss from a long term investment. The best part here is, you are also allowed to adjust this loss amount against any other capital gains for the current financial year, which reduces the tax burden even further. And if you are not able to adjust all or part of such loss in current year, you can carry forward this loss to next year also. IT rule allows you to carry forwards these losses for the next 8 years until it’s exhausted.
Hope you got the point how Indexation plays an important role on Long Term Capital Gain Tax. Remember, not only on redemption of long term debt funds, indexation helps to reduce taxes, but also while you make some switches from one scheme to another scheme (fyi, gains out of such switches are also taxed).
Do you know that Dividend Distribution Tax is another form of cut which reduces your net yield from your investment from debt funds returns? Thought dividend income is tax free in the hand of investors, but the mutual fund company has to pay a dividend distribution tax (DDT) before distributing this income you.
You may read the article; Understand the concept of Mutual Funds paying Dividend Distribution Tax (DDT)
Thus while choosing any debt fund as an investment option do not forget to do your mathematics and recall the below points
- What should be your post tax returns from such investment whether LTCG or STCG
- Since dividend income is tax free, but look at whether it really make sense opting the option or better go for growth plan
- Short Term Capital Loss can be set off against any Capital Gain (whether Long Term or Short Term) and Long Term Capital Loss can be set off only against Long Term Capital Gain.
- Also note, losses under the head “Capital gains” cannot be set off against income under other heads of income.
You might want to read the article; Investing just to get Higher Returns or Tax Adjusted Returns
Important points for NRI Investors:
Under Section 195 of Income Tax Act, Asset Management Companies (Mutual Fund House) are required to charge applicable TDS on any capital gains before releasing them to NRIs. For NRIs TDS on short term capital gains for debt funds are 30.90% and TDS on long term capital gains are 20.60% (With benefit of indexation). Even on switching from one scheme to another scheme, the investor is liable to TDS at the applicable tax rate. Mutual Fund Company issue a TDS certificate in the name of the NRI investor mentioning the details of the transaction and the tax deducted. The TDS certificate is commonly known as Form 16A. If the actual taxation is lower, NRIs can claim the refund through filing Income Tax Returns.