Know everything about Debt Mutual Fund Taxation

The world of mutual funds is vast, with different schemes to suit different needs. Broadly, there are three types of mutual funds – equity, debt, and hybrid. Each has a different asset allocation, risk-return profile, taxation rules, and so on. In this article, we will explore debt mutual funds and understand debt mutual fund taxation.

What is a debt mutual fund?

A debt mutual fund is a type of mutual fund scheme that invests in fixed-income securities such as commercial papers, corporate bonds, certificates of deposit, etc. These securities have a fixed maturity period and interest rate. There are different types of debt funds, such as overnight, liquid, money market funds, etc., based on their maturity period. Debt funds can also be categorised based on their management style as active and passive debt funds.

Tax on debt mutual funds explained!

When you sell your debt mutual fund units, the gains therefrom are known as capital gains. There are two types of capital gains based on how long you hold your investment – short-term gains and long-term gains. Here’s how they are taxed:

1. Debt mutual fund taxation: Short-term gains

When you stay invested in the fund for 36 months or less, the gains you earn on redemption are classified as short-term gains. These gains will be added to your income and taxed as per your income tax slab.

2. Debt mutual fund taxation: Long-term gains

When you stay invested in the fund for more than 36 months, the gains you earn on redemption are classified as long-term gains. These gains attract a 20% capital gains tax plus applicable surcharge and cess. You also get indexation benefits in this case. This means your investment cost is adjusted for inflation.

Say, you invest Rs 1000 in a debt mutual fund and get Rs 2000 on redemption. Your investment cost, which is Rs 1000, will be increased by adding the inflation factor. Suppose your indexed cost of investment comes to Rs 1500. In this case, your profits for the purpose of taxation will be Rs 500 (2000-1500) instead of Rs 1000 (2000-1000). You will, therefore, have to pay tax only on Rs 500.  

Wasn’t indexation simple? Numbers make everything easy. So, let’s understand the taxation of short-term and long-term capital gains with the help of numerical examples.

Case 1: When you sell your debt mutual funds within three years of investment: Short-term capital gain tax on debt mutual fund

Mr X invested Rs 50,000 in a debt mutual fund in Feb 2017. He redeemed his investment in Feb 2018 and earned a gain of Rs 10,000. He has a taxable income of Rs 18 lakh and falls under the tax bracket of 30%. In this case, Rs 10,000 will be added to Rs 18 lakh, and Rs 18.1 lakh will be taxed according to his slab rate.  

Case 2: When you sell your debt mutual funds after three years of investment: Long-term capital gain tax on debt mutual fund

Mr X invested Rs 50,000 in a debt mutual fund in Feb 2017. He redeemed his investment in Feb 2021 and earned a gain of 10,000. However, since he is entitled to receive indexation benefits, he will not be taxed for the entire Rs 10,000.

Here’s how he will be taxed post indexation:

#Note:

The Cost Inflation Index (CII) for every year is available on the official website of income tax in India. To adjust your investment amount for inflation, you can use the following formula:

Indexed cost of investment = Investment amount X CII for redemption year/CII for investment year

The CII for 2016-17 is 264, and for 2020-2021 is 301. Therefore, the indexed cost of investment = 50,000 X 301/264 = 57008.

How much is the Dividend Distribution Tax (DDT) on debt mutual funds?

Earlier, the dividends earned on mutual funds were tax-free in the hands of investors. Fund houses deducted DDT before paying it to investors. Currently, the entire dividend is taxable as per your income tax slab under the head ‘income from other sources’.

To sum it up

Debt mutual funds are low-risk investments that can help you maintain stability in the portfolio. The gains on such funds are classified as short-term and long-term gains based on the holding period and are taxed differently. It is important to understand the taxability of debt funds for planning your financial goals better.

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