Taxation On Debt Mutual Funds

The taxation of debt mutual funds depends on the date of purchase and their holding period. For units purchased on or after 1st April 2023, any gains from transfer, redemption, or maturity are treated as short-term capital gains and taxed at the investor's applicable slab rate, irrespective of the holding period.

However, for units purchased before 1st April 2023, the tax treatment varies based on how long they are held. If held for more than 2 years, the gains are taxed as long-term capital gains at a flat rate of 12.5% without indexation benefits. If held for 2 years or less, they are taxed as short-term capital gains at the investor's slab rate.

What are Debt Mutual Funds?

Debt mutual funds are investment instruments that primarily invest in fixed-income securities such as bonds, treasury bills, commercial papers, debentures, and other debt instruments. These funds generate returns mainly through interest income and occasional capital appreciation, making them an attractive option for conservative investors seeking stable and predictable returns with lower risk compared to equity funds. For taxation purposes, a mutual fund is classified as a debt mutual fund if it invests more than 65% of its total proceeds in debt and money market instruments. 

Taxation Of Debt Mutual Funds After 1 April 2023

From 1st April 2023, the taxation of debt mutual funds has changed significantly due to amendments in Budget 2023. Any gains arising from the transfer, redemption, or maturity of units of debt mutual funds purchased on or after this date will be treated as short-term capital gains, regardless of the holding period. These gains will be taxed at the investor’s applicable slab rates, and the benefit of indexation will no longer be available, as such funds are no longer classified as long-term capital assets. 

However, if the investment was made before 1st April 2023, the earlier rules will continue to apply. In such cases, if the units are held for more than 24 months, the gains will be considered long-term capital gains and taxed at 12.5% without indexation benefits. If held for 24 months or less, they will be taxed as short-term capital gains at the applicable slab rate.

This can be summarised as follows:

Taxation Of Debt Mutual Funds Before 1 April 2023

Before 1st April 2023, the taxation of debt mutual funds was based on their holding period. If a debt mutual fund unit was sold within 36 months (three years) of purchase, the gains were classified as short-term capital gains (STCG) and taxed at the investor’s applicable slab rates. However, if the units were sold after 36 months, the gains were treated as long-term capital gains (LTCG) and taxed at 20% with the benefit of indexation. The indexation benefit allowed investors to adjust their purchase cost for inflation, effectively reducing their taxable gains and the overall tax liability.

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.

Illustration for Tax Treatment before Amendment 

Example 1: Mr X invested Rs. 10 lakhs in FY 2020-21 in a debt mutual fund and sold the investments after four years of holding them in FY 2024-25 on or after 23rd July, 2024 for a sale value of Rs. 20 lakhs, thereby earning a capital appreciation value of Rs. 10 lakhs. 

Illustration for Tax Treatment after Amendment 

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

*The above calculation is based on the assumption that there is no other income for the assessee during the financial year. 

Comparison Of Fixed Deposits And Mutual Funds Taxation

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

While recent tax changes have made debt mutual funds similar to fixed deposits in terms of taxation, debt mutual funds still offer several advantages over FDs. Unlike regular FDs, which often impose penalties on premature withdrawals, debt mutual funds generally have no exit load after a certain period, making them more liquid and cost-effective. Additionally, debt mutual funds tend to provide higher returns compared to fixed deposits. Another benefit is in their taxation: 

• profits from debt mutual funds are treated as capital gains, allowing investors to carry forward and set off losses against future gains, 
• while interest earned on fixed deposits is taxed as ‘income from other sources’ with no such set-off benefit. 

These factors make debt mutual funds a potentially better option for tax efficiency and returns compared to traditional FDs.

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