How to improve debt fund returns by optimizing tax on debt funds

Debt fund returns can be significantly improved by deciding when you sell them, thereby reducing the effective tax on debt funds. We review these against 16 newly announced (debt fund) categories by SEBI

Tax on Debt Funds

Short-term gains from debt funds are added to your income and are subject to short-term capital gains tax (SCGT) as per the income tax slab you fall under.

Long-term capital gains on debt fund however are taxed at the rate of 20% after indexation. Indexation provides mechanism to adjust nominal gains against inflation.

You can take the rate of inflation used for indexation from the government’s Cost Inflation Index (CII). The Central Government determines the values in the index and updates these on the Income Tax Department’s website. You can view the Cost Inflation Index from 1981 onwards.

Example

Suppose you invested in debt fund worth 10,000 rupees in FY10 which you eventually sell for 17,500 rupees after 5 years in FY15, giving a gross return of 11.8% CAGR

Net profits after indexation would be = Sale consideration – Purchase consideration * (2015 CII/ 2010 CII) = 17,500 – 10,000*(240/148) = 1,283

Income tax at 20% LTCG would be = 256.

As you can see, the effective interest rate after indexation is much lower at 3.4% and not 20%.

Let’s examine the impact of time on tax adjusted returns of debt funds:

Assuming a marginal taxation rate of 30%, we can see that it’s not advisable to sell before 3 years. Higher short term tax rates significantly reduces the effective rate of returns after tax.
Recommendation is to sale around year 4 to maximise gains – assuming everything else remains constant.

Debt fund returns against 16 new categories

Debt Mutual Funds in India come in 16 distinct flavours. This is following SEBI’s order in October 2017 to reclassify schemes in order to bring uniformity in way funds are categorised in the industry.

Overnight funds

These open-ended debt schemes will invest in overnight securities. Investment in overnight securities have maturity of one day.

Liquid funds

These schemes will invest in debt and money market securities with a maturity of up to 91 days.

Ultra short duration funds

These open ended ultra-short term debt schemes will invest in instruments with a maturity between three months and six months.

Low duration fund

These open-ended debt schemes will invest in instruments with a duration between six months and 12 months.

Money market funds

These open-ended debt schemes will invest in money market instruments with a maturity of up to one year.

Short duration funds

These open-ended debt schemes will invest in instruments with a duration between one year and three years.

Medium duration funds

These open ended debt schemes will invest in instruments with a duration between three years and four years.

Medium to long duration funds

These open-ended debt schemes will invest in instruments with a duration between four years and seven years.

Long duration funds:

These open-ended debt schemes will invest in instruments with a duration of greater than seven years.

Dynamic bonds

These open-ended debt schemes will invest across durations.

Corporate bond funds

These open-ended debt schemes will predominantly invest in highest-rated corporate bonds. These schemes should invest at least 80 per cent of total assets in corporate bonds, only in highest-rated instruments.

Credit risk funds

These open-ended debt schemes will invest in below highest-rated corporate bonds. They should invest at least 65 per cent of the total assets in corporate bonds.

Banking and PSU funds

These open-ended debt schemes will predominantly invest (80 per cent of assets) in debt instruments of banks, public sector undertakings and public financial institutions.

Gilt funds

These are open-ended debt schemes will invest in government securities across maturity. These schemes should invest a minimum of 80 per cent of its total assets in G-secs.

Gilt fund with 10-year constant duration

These open-ended debt schemes will investing in government securities with a constant maturity of 10 years. These schemes should invest at least 80 per cent of the total assets in G-secs.

Floater funds

These open-ended debt schemes will mostly invest in floating rate instruments. These schemes will invest at least 65 per cent of the total asses in floating rate instruments.

Conclusion

As we saw, returns on debt funds can be significantly improved by deciding when to sell and thereby reducing the effective tax on debt funds.

Indexing has ability to reduce effective  tax rates by making adjustments for inflation. You should sell debt mutual funds preferably around year 4, everything else remaining constant.

 

 

 

 

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