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Knowing the tax norms of the investment option under consideration is important. It helps you plan your finances accordingly. Not being aware of your tax liability might give you an unpleasant surprise. Debt funds are a class of mutual funds whose asset allocation is made mostly towards fixed-income assets across both debt and money markets. We have covered the following in this article on the taxation of debt funds:
As per the norms of the Income Tax Act, 1961, the dividends offered by debt mutual funds are taxable in the hands of investors. Dividends received by investors are added to their overall income and taxed at the income tax slab rate they fall under. This way of taxing dividends in the hands of investors is referred to as the classical way of taxing dividends. This is in place after the amendments made in Budget 2020.
Until Budget 2020, dividends were made tax-free in the hands of investors as the companies paid a dividend distribution tax (DDT). In the case of debt funds, the companies were supposed to pay a DDT at the rate of 29.12%, including the applicable cess and surcharge. Irrespective of the tax slab of investors, the dividends received were tax-free in their hands.
As per the existing norms for taxing dividends offered by debt funds, if you fall under the 20% income tax bracket, you will pay Rs 20 for every Rs 100 received as dividends. The reintroduction of the classical way of taxing dividends in the hands of investors at their respective income tax slab rate has increased the tax outgo for investors who fall under the higher tax bracket.
The taxation of capital gains offered by debt funds depends on the holding period. It is defined as the duration for which you let your money stay invested in a fund. If your holding period is less than three years, it is termed as ‘short-term’, and the resulting capital gains are called the ‘short-term capital gains’. Your debt fund holdings are termed ‘long-term’ if the holding period is longer than three years, and the resulting gains are referred to as the ‘long-term capital gains.
Short-term capital gains are taxed similar to dividends. They are added to your overall income and taxed at the income tax slab rate you fall under. You will also have to pay the applicable cess and surcharge on it. For example, if you are in the 30% tax slab, you will be paying short-term capital gains tax at 31.2% (30% + 4% cess).
Long-term capital gains offered by a debt fund is taxed at a flat rate of 20%. This special rate of taxation is irrespective of the income tax slab rate of the inventors. Also, tax long-term capital gains tax is calculated after indexation, which helps investors to reduce their tax liability to a great extent.
With the help of indexation, you can reduce the tax outgo on your long-term capital gains earned on the debt fund investments. Indexation is the procedure that allows you to reduce the cost of purchase of your fund units to factor in the inflation rate between the time at which you sold the fund units and bought them. Here, the inflation index (CII) cost is utilised to index the debt fund units’ purchase price.
Index purchase price = (CII of the year of sale of units / CII of the year of purchase) x (Cost of purchase)
You can read more about indexation here.
Knowing how debt funds are taxed is important. Holding onto your debt funds for a longer duration is beneficial as you will pay capital gains tax at 20% after indexation.