Taxation On Debt Mutual Funds

Amendment to Finance Bill 2023 scrapped the indexation benefit on debt mutual funds. They will now be taxed at investor’s slab rates. These changes will bring the taxation of specified mutual funds at par with fixed deposits. Read on to know how this move may impact you and everything about the taxation of debt mutual funds.

What are Debt Mutual Funds?

Before discussing the changes, it is important to understand debt mutual funds and their current tax framework. Debt mutual funds are investment instruments which predominantly invest their funds in fixed-income securities like bonds, treasury bills, commercial papers, debentures, and other debt instruments. These securities usually generate returns in the form of interest or capital appreciation, which makes them a preferred investment choice for conservative investors.

For taxation purposes, a specified mutual fund invests more than 65% of its proceeds in debt and money market instruments. 

Taxation Of Debt Mutual Funds After 1 April 2023

The Budget 2023 has brought about certain amendments that imply that any gains arising from a transfer of units of Specified Mutual Funds bought on or after 1st April 2023 will be deemed as short-term capital gains irrespective of their holding period. Therefore, debt mutual funds will now be taxed at slab rates. 

Indexation benefits will also not be available now as such funds can no longer be classified as long-term capital assets.

However, if the investment in such specified mutual funds was made before 1st April 2023, then the concept of Long-term capital gains will still be applicable. In such a case, to qualify as a long-term asset the investor should have held the units for more than 24 months from the date of acquisition. The gains will be taxed at 12.5% and indexation will not be available.  

This can be summarised as follows:

Taxation Of Debt Mutual Funds Before 1 April 2023

Earlier, the taxation of debt mutual funds was governed by the holding period rule:

• Short-Term Capital Gains: If the debt mutual fund unit is sold within 36 months (three years) of purchase, the gains are termed short-term capital gains (STCG). These STCGs were taxed at slab rates. 
   
• Long-Term Capital Gain: However, if they were sold after 36 months, then the gains were termed long-term capital gains (LTCG). These long-term capital gains were taxed at 20% with an indexation benefit. Indexation benefit means the gains made by investors were adjusted for inflation. This is illustrated in the table below.

How Will The Changes In Income Tax Rules Affect Taxation On Debt Mutual Funds?

Let us consider the tax flow on debt funds before and after the amendments.

Example 1: Mr X invested Rs. 10,00,000 in FY 2020-21 in a debt mutual fund and sold the investments after three years of holding them in FY 2023-24 for a sale value of Rs. 20,00,000, thereby earning a capital appreciation value of Rs. 10,00,000. 

Tax Liability in the same scenario but after the changes (from Financial Year 2023-24)

Example 2: Mr. X invested Rs. 20,00,000 in a debt mutual fund in FY 2024-25. He sold the units in FY 2025-26 for Rs. 30,00,000. In this scenario, as the investment was made after 1st April 2023 the gains will be deemed as short-term capital gains irrespective of the holding period. The computation will be as follows:

Assuming that Mr. X opts for the New Tax Regime

Comparison Of Fixed Deposits And Mutual Funds Taxation

Are Fixed Deposits(FDs) Better Than Debt Mutual Funds?

Despite the recent developments that suggest debt funds are now comparable to fixed deposits, there are still several compelling reasons why debt funds can be a great tax-saving investment option: 

• For instance, unlike fixed deposits, debt mutual funds are only subject to taxation when the investments are sold. Therefore, it can help you in deferring taxes.
• Flexi FDs offer the flexibility to withdraw funds without penalty. However, if you opt for regular FDs, you may have to pay the penalty for early withdrawal. Conversely, debt funds impose no exit loads after a certain period. Therefore, debt funds provide greater liquidity and can be more cost-effective than Bank FDs.
• Debt funds typically yield higher returns than fixed deposits.
• Profits from Debt mutual funds are classified as capital gains, while fixed deposits are categorised as ‘income from other sources’. This means that in the event of losses with debt mutual funds, they can be carried forward and offset against gains.

Related articles:

• What are Debt funds and it's types?
• Debt Fund - Maturity and Duration
• Calculate tax liability on Debt Funds investments.
• Mutual Fund Taxation