Debt mutual funds are a popular investment option for many investors who want to earn steady returns and diversify their portfolio. However, many investors are not aware of the tax implications of debt mutual funds and how they can save tax by using indexation.
In this blog post, we will explain what debt mutual funds are, how they are taxed, and how indexation can help you reduce your tax liability. We will also show you an example of how to calculate your tax liability on debt mutual funds with indexation.
What are Debt Mutual Funds?
Debt mutual funds are mutual funds that invest mainly in fixed-income securities such as bonds, debentures, treasury bills, corporate deposits, and money market instruments. These securities pay interest or coupon payments at regular intervals and have a fixed maturity date.
Debt mutual funds are suitable for investors who want to earn regular income, preserve their capital, and have a low risk appetite. Debt mutual funds can also offer higher returns than bank fixed deposits or savings accounts, depending on the interest rate scenario and the credit quality of the underlying securities.
How are Debt Mutual Funds Taxed?
The taxation of debt mutual funds depends on the holding period of the investment. The holding period is the duration for which you hold the units of the debt mutual fund before selling them.
If you sell your units within 36 months (three years) of purchase, the gains are termed as short-term capital gains (STCG). These gains are added to your other income and taxed at your slab rate.
If you sell your units after 36 months, the gains are termed as long-term capital gains (LTCG). These gains are taxed at 20% with indexation benefits.
What is Indexation?
Indexation is a method of adjusting the purchase price of your investment according to inflation. This reduces the taxable amount of your gains by increasing the cost of acquisition.
Indexation is done by using the cost inflation index (CII), which is notified by the government every year. The CII reflects the change in the general price level in the economy over time.
To calculate the indexed cost of acquisition, you need to multiply the original purchase price by the ratio of the CII of the year of sale to the CII of the year of purchase.
For example, suppose you bought 1000 units of a debt mutual fund at ₹10 per unit in April 2018 and sold them at ₹15 per unit in May 2021. The CII for 2018-19 was 280 and for 2021-22 was 317.
The indexed cost of acquisition = ₹10 x (317/280) = ₹11.32
The LTCG = (₹15 - ₹11.32) x 1000 = ₹3680
The tax on LTCG = ₹3,680 x 20% = ₹736
Without indexation, the LTCG would be ₹5,000 and the tax would be ₹1000.
As you can see, indexation helps you save tax by reducing your taxable gains.
How to Calculate Your Tax Liability on Debt Mutual Funds with Indexation?
To calculate your tax liability on debt mutual funds with indexation, you need to follow these steps:
- Identify your holding period for each debt mutual fund investment.
- If your holding period is less than 36 months, calculate your STCG by subtracting the purchase price from the sale price and add it to your other income.
- If your holding period is more than 36 months, calculate your LTCG by subtracting the indexed cost of acquisition from the sale price.
- Apply the tax rate of 20% on your LTCG and add it to your tax liability.
- Add any applicable surcharge and cess to your tax liability.
Conclusion
Debt mutual funds are a good investment option for investors who want to earn steady returns and diversify their portfolio. However, they also have tax implications that need to be considered before investing.
By using indexation, you can reduce your tax liability on debt mutual funds by adjusting your purchase price according to inflation. This will help you save tax and increase your post-tax returns.
We hope this blog post has helped you understand how to calculate your tax liability on debt mutual funds with indexation.
Happy investing!
Disclaimer
The investment options and stocks mentioned here are not recommendations. Please go through your own due diligence and conduct thorough research before investing. Investment in the securities market is subject to market risks. Please read the Risk Disclosure documents carefully before investing. Past performance of instruments/securities does not indicate their future performance. Due to the price fluctuation risk and the market risk, there is no guarantee that your personal investment objectives will be achieved.