The main objective of any investment is to earn money from it. However, when you invest in mutual funds, it generates capital gains which are taxable. Thus, taxation forms an integral part of any investment as your returns are reduced to the extent of taxes paid. In the end, what matters is the amount you are left with. It is therefore of prime importance to understand how taxation can impact your earnings from investments . The tax you pay on capital gains depends on the duration for which you invest in debt funds or other respective schemes. For example, gains on debt mutual funds for 36 months or more are treated as long-term and taxed at 20% after indexation.
Let us start by understanding the basics.
What are debt funds?
Debt funds are one of the types of mutual funds that invest in fixed-income generating securities. These securities include treasury bills, corporate bonds, commercial paper, government securities and other money-market instruments. You can earn interest income and capital appreciation by investing in debt funds. Usually, portfolio managers charge a total expense ratio for managing your investments. It can fluctuate based on the type of mutual fund you invest in.
Types of holding periods
As mentioned before, the period for which you stay invested determines the tax you pay on capital gains. This is known as the holding period of mutual funds. There are two types of holding periods:
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Long-term holding period
In the case of equity funds and balanced mutual funds, a holding period of 12 months or more is regarded as long-term. Whereas, for debt funds, a holding period of 36 months or more is regarded as long-term. So, long-term capital gains tax or (LTCG) applies to all those investments. For example, if you invested in a debt fund in June 2015 and redeemed your investments in August 2018, it will attract LTCG tax on your capital gains.
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Short-term holding period
A holding period of fewer than 36 months is regarded as short-term for debt mutual funds. For equity mutual funds and balanced mutual funds, a period of fewer than 12 months is regarded as a short-term holding period. For example, if you invested in a debt fund in June 2015 and redeemed your investment in January 2017, it will attract STCG tax on your capital gains.
Taxation on debt mutual funds
Short-term capital gains on debt mutual funds are to be added to your overall income. They are subject to short-term capital gains tax as per your applicable income tax slab.
For long-term capital gains on debt funds, a tax rate of 20% is levied after indexation. Indexation is a method to account for the rise in inflation between the year when the debt funds were sold, and the year they were bought. This brings down the quantum of capital gains by inflating the purchase price of debt funds. Thus, you end up paying lower tax than what you would otherwise pay without the indexation benefit.
Calculation of tax on debt funds
Let us understand the tax calculation on debt funds using an illustration.
Assume a debt fund generates a return of 9% p.a. and the Cost Inflation Index (CII) is 5% p.a. The effective tax rate becomes 9.69%. The following calculations show how:
Expected Debt Fund Returns p.a. – 9%
Investment (Rs) – 1,00,000
Value of Investment after 3 years (Rs) – 1,29,503
Indexed Cost (Rs.)* – 1,15,765
Capital Gains (Rs) – 13,740
Tax Rate – Debt – 20.80%
Tax (Rs) – 2,858
Actual Gains (Rs) – 29,503
Effective Tax Rate – Debt – 9.69%
*Indexed Cost = Actual Purchase Price *(Index in year of sale / Index in year of purchase)
CII assuming an inflation rate of 5% p.a.
CII 2018-19: 280, CII 2019-20: 294, CII 2020-21: 308.70, CII 2021-22: 324.14
Conclusion
Thus, if you invest in mutual funds for the long term, they become more tax-efficient.