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How is the Tax Liability in Debt Mutual Funds Calculated?
Apr 12, 2023
4 min | Views 6536
Summary
Planning to invest in debt funds or redeem your investment? Find out how debt mutual funds are taxed to make an informed decision.
Content
Mr Gaurav invested â‚ą3 lakhs in a debt mutual fund (growth scheme) 2 years ago. Now that he plans to redeem his investment, he's unaware of how his gains will be taxed. Not knowing the tax liability of your investment is a classic beginner's mistake. Taxes can significantly impact the returns you generate from your investment and deserve your utmost attention.
Nevertheless, let’s help Gaurav calculate the tax liability on his debt fund investment.
How are Debt Mutual Funds Taxed in India?
There are two major tax liabilities on mutual fund investments in India.
â—Ź Capital gains tax
â—Ź Tax on dividends
While dividends are added to the investor’s income and taxed as per the applicable tax slab rate, capital gains tax depends on the type of fund and the holding period.
All the mutual funds in India are classified as either equity or debt fund for tax purposes. The tax liability varies for equity and debt fund. Any scheme investing less than 65% of its portfolio in equity is classified as a debt fund.
Types of Mutual Funds
How are Capital Gains from Debt Funds Taxed?
Capital gains are the profits you generate by selling any asset at a price higher than its buying price. For instance, if Gaurav invested ₹3 lakhs in a debt fund when the NAV of the scheme was ₹100 and is redeeming the investment after 2 years when the NAV was ₹120, he earned a profit of ₹20 per unit. So, on his 3,000 units (₹3 lakh/₹100 ), he’ll be generating capital gains of ₹60,000.
The capital gains from a debt fund are taxed based on the holding period of the investment. If the investment is held for up to 3 years, it is treated as Short-Term Capital Gains (STCG). Such gains are added to the investor's taxable income and taxed as per their tax slab.
But if the investment is held for over 3 years, it is considered Long-Term Capital Gains (LTCG) and is taxed at 20% with indexation benefit.
Investment Horizon |
Type of Gains |
Tax Rate |
Up to 3 years |
(STCG |
Added to the taxable income of the investor and taxed as per their tax slab (plus surcharge and cess) |
3 years or more |
LTCG |
20% with indexation (plus surcharge and cess) |
How are Dividends from Debt Funds Taxed?
When investing in mutual funds, you can choose between growth and IDCW plans. IDCW (Income Distribution cum Capital Withdrawal) plans, previously known as dividend plans, distribute dividends among the investors at regular intervals. Such dividends are reinvested in the scheme with growth plans.
Until 2020, dividends from debt mutual funds were taxed at the hands of the fund house, and investors would get dividends after deducting this tax. However, Budget 2020 made significant changes to this practice. Now, the dividends from debt funds are taxed at the hands of the investors as per their applicable tax slab. For instance, if you fall in the 20% tax slab, you’ll be paying ₹20 on every ₹100 dividends you receive.
How is STCG from Debt Funds Taxed?
STCG from debt mutual funds is added to the investor's taxable income and taxed as per their tax slab. As Gaurav is redeeming his investment after 2 years, the gains of â‚ą60,000 will be added to his taxable income.
Income Tax Slab Rate- 30% Applicable STCG Tax Rate- 30% (+ surcharge + cess) STCG- â‚ą60,000 Tax Amount- â‚ą18,000 (+ surcharge + cess)
For instance, if he is in the 30% tax slab, his STCG of ₹60,000 will be taxed at 30% (+ surcharge + cess). Here’s how the calculation will work out-
How are Long-Term Capital Gains from Debt Funds Taxed?
As mentioned above, LTCG from debt mutual funds is taxed at 20% with an indexation benefit.
In the above example, let’s assume Gaurav redeemed the investment after over 3 years. During the 3 years, Gaurav’s value in the fund increased from ₹300,000 to ₹380,000.
Thus, he made a gross gain of â‚ą80,000.
So does this mean he will be liable for LTCG of 20% on â‚ą80,000?
No.
This is because Gaurav is also supposed to get an indexation benefit on the gains made. Let's look at this in detail.
What is Indexation Benefit in Debt Funds?
Indexation helps reduce your tax outgo on the LTCG from debt funds. With indexation, the purchase or acquisition cost of the mutual fund unit is adjusted for the inflation rate of the investment period.
The Income Tax Department’s Cost Inflation Index (CII) is used for the calculation. Here’s how the Indexed Cost of Acquisition (ICoA) is calculated-
ICoA= Acquisition Cost x (CII of Sale Year/CII of Purchase Year)
So, assuming Gaurav wanted to redeem the units in August 2022 and the purchase was in July 2019 (holding period of above 3 years), the equation will be-
ICoA= 343,600 [300,000 x (331/289)]
Now, the indexed capital gains will fall from â‚ą80,000 (â‚ą380,000-300,000) to â‚ą36,400 (â‚ą380,000-â‚ą343,600).
The LTCG tax of 20% will be applicable on â‚ą36,400 and not â‚ą80,000.
As a result, the tax outgo will reduce from â‚ą16,000 (+ cess + surcharge) to â‚ą7,280 (+ cess + surcharge) with indexation. Moreover, the longer the holding period, the higher the tax benefit with indexation will be.
Click Here to Know More About the ITR Meaning
Know the Tax Norms Before Investing in Debt Funds
The lower potential risk of debt funds makes them an excellent choice for risk-averse investors. You can also add them to your portfolio for diversification. But before investing, ensure you thoroughly understand how to calculate your tax liability in debt mutual funds.
Use the information above or consult an investment advisor to make the most of your investment.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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