Taxation plays a vital role in any investments as capital gains and interest earned on the investment are reduced to the extent of taxes paid. Ultimately, what matters to the investors is what is left in hand after taxes are paid. It is, therefore, imperative for the investors to know about the impact of taxation on earnings from investments. Our current topic is on debt mutual funds and the taxation applicable to them. The amount of capital gains tax to be paid on mutual funds depends on the type of investment (equity / debt) and the duration of time for which the investment is held.
The table below shows the Long Term Capital Gains (LTCG) tax details for debt & equity funds:
Assuming a debt fund generates a return of 9% p.a. and the Cost Inflation Index (Cll) is 5% p.a., the effective tax will come to about 9.69%. Following table will illustrate the same:
*Indexed Cost = Actual Purchase Price *(Index in year of Sale / Index in Year of Purchase)
Ideally, a debt fund could be compared to a fixed deposit or a bond which pays interest. Interest income from fixed deposits and taxable bonds is added to the individual's total income and is taxed as per the tax slab applicable to the individual's total income.
Another category of funds which was popular earlier were Monthly Income Plans (MIPs). These funds were structured to have a small component of equity, of say between 10-20% and the balance would be debt. They lost their charm when dividend distribution tax (DDT) was introduced. This gave rise to equity savings funds, which have 35% exposure to arbitrage (classified as equity for taxation) and 30% to pure equity and 35% to debt. These funds became popular because of their taxation advantage. However, in the recent budget with the introduction of taxation on equity oriented funds the equation has undergone a slight change. Though equity savings funds still retain the upper hand as the holding period for LTCG is one year, compared with three years for debt schemes, the 10% tax on LTCG from equity funds has reduced the tax disparity. The Indexation benefit available for long term capital gains from MIP funds makes these schemes fairly tax-efficient. Indexation can significantly reduce the effective capital gains, reducing the tax liability for the investor.
Going ahead, for investors holding hybrid funds for the long term, there will not be much difference in the tax rate; what will matter is allocation to equity and the holding period.
Impact of Dividend Distribution Tax
Dividend Distribution Tax on debt mutual funds (including surcharge and cess) is at the rate of 29.12% for individuals and 34.94% for corporates. So, if the dividend is 7%, individuals will earn 4.96% net of tax and for corporates the same will be 4.55%. Thus, investors should favour the growth option over the dividend option in debt oriented funds.
Thus, it is very important for investors to make the correct decision so as not to lose out on the returns due to taxation as this could otherwise reduce their post-tax returns substantially.