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.

Budget 2025 Updates

As per the budget 2025, the income up to Rs. 12,00,000 will have zero tax liability for the FY 2025-26 (AY 2026-27) under the new tax regime. Here's how:

The revised tax slabs under the new regime for FY 2025-26 (AY 2026-27) are as follows:

Income Tax Slabs	Tax Rate
Upto Rs. 4,00,000	NIL
Rs. 4,00,001 - Rs. 8,00,000	5%
Rs. 8,00,001 - Rs. 12,00,000	10%
Rs. 12,00,001 - Rs. 16,00,000	15%
Rs. 16,00,001 - Rs. 20,00,000	20%
Rs. 20,00,001 - Rs. 24,00,000	25%
Above Rs. 24,00,000	30%

With the revised tax structure, individuals earning up to Rs. 12,00,000 will have no tax liability due to the increased rebate of Rs. 60,000. For salaried individuals, the tax liability will be zero for incomes up to Rs. 12,75,000, due to the Rs. 75,000 standard deduction.

Note:

• The marginal relief on rebate is still applicable. 
• The rebate is not available for income that is taxed at special rates (e.g., capital gains under section 112A).

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 is one that invests less than 35% of its proceeds in the equity shares of domestic companies.

Taxation Of Debt Mutual Funds After 1 April 2023

The Budget 2023 has brought about certain amendments that imply that a Specified Mutual Fund will no longer receive indexation benefits when computing long-term capital gains(LTCG). Therefore, debt mutual funds will now be taxed at the applicable slab rates. 

Moreover, indexation benefits will not be available for LTCG on gold mutual funds, hybrid mutual funds, international equity mutual funds, and funds of funds (FOF). Consequently, mutual fund houses are likely to be adversely affected as investors may prefer to invest directly in debt securities rather than debt mutual funds to avoid AUM fees/charges. The change may also impact the attractiveness of these mutual funds as an investment option, as the tax burden on the profits may increase.

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.

Suppose 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)

Long-term capital gains tax before and after the recent changes in debt fund taxation:

As seen in the above example, the recent changes to debt fund taxation will negatively impact people falling under the 20%-30% tax bracket.

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