Taxation on Mutual Funds – Debt

February 13, 2019
financial freedom

Taxation on Debt Mutual Fund

Debt means loan. When you are investing in a debt mutual fund, you are lending money and earn interest on the money you have lent. The returns are reasonable. The basic reason behind investing in debt fund is to earn interest. Returns are tax-efficient. Tax efficiency in debt funds may be the single most important decision why you have to consider debt funds in your portfolio.

The holding period of debt mutual funds can be short term or long term.

Short Term for debt mutual fund is less than 36 months. Long Term for debt mutual fund is more than 36 months.

Short Term Capital Gain(STCG):  The gains from debt mutual fund redeemed before 36 months are treated as short term capital gain. It will be added to your income and taxed as per your applicable tax rate.

How to calculate Short Term Capital Gain Tax? Let’s assume you have invested Rs.6,00,000/- in a debt fund and the NAV of the fund is Rs.20/-. After one year, the NAV increased to 21.5/- and you want to withdraw Rs.45,000/-.  You are in the 31.2% (30% + 4% Cess) tax bracket. How to calculate short term capital gain tax?

NAV at the time of purchase = Rs.20/-

NAV at the time of redemption = Rs.21.5/-

Amount to withdraw = Rs.45,000/-

So, 45,000/21.5 = 2093 units. If you want to withdraw Rs.45,000/- from this debt fund, you have to sell 2093 units of this fund (we are ignoring fractions, for ease of understanding)

The formula for capital gain = sale price(21.5) – cost of acquisition(20) * the no. of units sold

Therefore, short term capital gain = (21.5 – 20)* 2093 = Rs.3140 . Please note that this is only the short term capital gain and not the tax thereof.

Short term capital gain tax (STCG) = 3140 * 31.2/100 = 980/-.

If you are investing the same Rs.6,00,000/- into a bank FD, after one year the bank gives you the interest as Rs.45,000/- (7.5% interest rate) and you are withdrawing the interest part of Rs.45,000/-, then the tax will be

= 45,000 * 31.2/100 = 14,040/-.

Rs.14,040/- of tax you have to pay on the bank deposit. Contrast this with the Rs.980/- of tax to pay on debt fund.

Long Term Capital Gain (LTCG): Gains on debt mutual fund held for more than 36 months are treated as Long Term Capital Gain (LTCG). Long Term Capital Gains are taxed at 20% with indexation benefit.

Indexation allows you to increase the purchasing price of the asset to compensate for inflation.  Inflation erodes the value of the asset over time. So inflation is also taken into account while calculating tax.

How to calculate indexation? For this, the government uses a tool called Cost Inflation Index or CII. This is the inflation index tool to measure the inflation of the economy. Every year the government publishes the Cost Inflation Index (CII). The CII for every year can be viewed on the Income Tax Department’s website. https://www.incometaxindia.gov.in/Pages/utilities/Cost-Inflation-Index.aspx

How to calculate Long Term Capital Gain Tax?

Let’s look at an example,

You invested in a debt fund in May 2013. Your investment amount was Rs.1,00,000/- . 3 years later, on July 2016, you sold the investment. It was Rs.1,26,000/- What is the tax?

Cost Inflation Index for 2013-14 = 939

Cost Inflation Index for 2016-17 = 1125

Therefore= Original cost* CII of year of sale / CII of year of purchase

                                 =1,00,000 * 1125 / 939 = Rs. 1,19,808/-. So, I am allowed to increase my purchase of Rs.1,00.000/-  to Rs.1,19,808/-

Therefore, capital gain = Sale price – Purchase price = 1,26,000 – 1,19,808 = 6192/-

LTCG (Long Term Capital Gain) Tax = 6192*20.8% = 1288/-

So the tax efficiency is the most important factorwhy you have to consider debt funds in your portfolio.

Tax on Dividends: Dividends from debt mutual funds are tax-free in the hands of the investor. But dividends are paid after deducting a Dividend Distribution Tax (DDT) at 29.12%. (25% base rate + 12% surcharge + 4% Health and Education Cess).

Balanced Mutual Funds: Balanced mutual fund is a combination of equity and debt. In a balanced mutual fund if the debt exposure is more than 35%, is considered as a debt-oriented balanced fund. Taxation of debt oriented mutual fund is as same as debt mutual fund. Tax rates are explained above.

^Assuming the investor falls into the highest tax bracket.

*surcharge at 15% is applicable where the income of individual/HUF exceeds Rs.1 crore and at 10% where income exceeds Rs.50 lakhs but does not exceed Rs.1 crore. No surcharge for income below Rs. 50 lakhs.

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