Changes in Debt Funds taxation: What it means for you

Padmaja Choudhury   /   April 4, 2023

The government has made a significant shift in the taxation of debt mutual funds. From 1st April 2023, there will no longer be long-term capital gains benefit with indexation for a holding period greater than three years. This change means investments will now be taxed as per your income slab, regardless of the investment duration.

In the current scenario, if investors invest in non-equity schemes, i.e., debt funds, gold ETFs, and international funds, for less than 36 months, they are currently subject to a marginal rate of interest tax. Investors can take advantage of 20% tax with indexation advantages for holding periods longer than 36 months, which makes them attractive compared to other traditional saving instruments such as bank FDs, National Savings Certificate(NSC) and others.

What can debt fund investors do?

While this might come as a blow to many investors, now that it is here, we need to understand how to go about it.

With indexation benefits out of the picture, it may adversely impact the tax you have to pay on your debt funds investment. Indexation acted as compensation for inflation. However, if we compare bank FDs, debt funds still have the upper hand. It is because the returns in debt funds accumulate and compound over time. This is not the case in FDs. In FDs, the interest income above ₹40,000 for individuals below 60 years is subjected to a 10% TDS (Tax Deducted at Source). In addition, interest on FDs comes under ‘income from other sources’ and is added to the total income and taxed accordingly. But in debt funds, there is no tax on returns until you redeem your units. Hence, even though the returns on debt funds might be similar to other debt products, there is potential to earn more in a debt fund.

Also, open-ended debt funds are extremely liquid. You can invest and redeem at any time. However, with bank FDs, you might have to pay a penalty charge for early withdrawal.

In addition to debt funds, the recent changes also impact international funds. However, there is an exemption for funds with 35% or more of their equity invested in domestic markets. As a result, you can look at funds that invest in domestic and international stocks.

If you are into gold funds and gold ETFs, you can look at sovereign gold bonds if you have an investment horizon of seven years. However, the primary issuance of these bonds is open during certain days of the year as per the schedule fixed by RBI. Liquidity might also be an issue if you sell your investments before seven years.

Conclusion: This blog post explored the key change in non-equity funds and what it means for investors like you. It is important not to make rash decisions and to make informed decisions about future investments in debt funds.