Taxation on investment always confuses people especially when they are investing in multiple investment instruments like the stock market, mutual funds, debt fund, FD, and many others. Debt Fund Taxation in India is not that complicated but sometimes, it is confusing for many new investors. It is very important to pay the taxes on time to avoid any notice from the income tax of India.
Debt Funds are a favorite investment instrument for many investors and they prefer it over other safer investment options. But, there are 16 types of debt funds are available and income taxes are applicable accordingly. Then, how to calculate the taxes applicable to debt fund earnings? Let’s understand the debt fund taxation in detail.
What are Debt Funds?
Debt Funds are the fund houses that pool money from many investors/retails investors and invest money in Commercial Papers, Commercial Deposits, Corporate Bonds, etc. These are the safest investment options available because they invest only in private or government bonds which are rated high by the credit rating agencies.
They provide greater flexibility on investment horizon and allows retail investors to invest safely in corporate bonds which are difficult to invest and manage directly. Debt Fund’s returns might not beat mutual fund’s but the returns are stable and consistent. This is one of the reasons, investors are considering debt funds as an alternative to Fixed Deposit.
Apart from all these, debt funds get the benefit of indexation which adds more profit after fund maturity. However, it only applies to the long term capital gain. Before we jump into Debt Fund Taxation login, let’s try to understand the Debt Fund Indexation. You can check out my previous article on the Benefits of investing in Debt Fund.
What Is Debt Fund Indexation?
Debt Fund Indexation is a method of adjusting the initial investment amount for inflation. Usually, it increases the value of the initial investment amount unless there is deflation.
To calculate the Debt Fund Indexation, fund houses use CII i.e. Cost Inflation Index. The income tax department of India publishes the early CII value for each financial year. To calculate the indexation value first, they divide the CCI value of the fund maturity financial year with CCI value of investment financial year and multiple the resulted value with the initial amount.
This increases the initial investment value if the inflation rate is increasing and could decrease the value in case of deflation.
How does indexation impacts the profit value?
Well, your investment value is adjusted with the inflation rate which results in lower taxable profit. Income taxes are applicable only on the taxable returns in indexation helps in reducing it. It will show the significant difference in profit if you fall under a 30% income tax slab.
Remember, Debt Fund Indexation only applicable on Long Term Capital Gain i.e. if debt fund investment made for more than 3 years.
Now, let’s understand the debt fund taxation in India.
Understanding Debt Fund Taxation In India
There are two types of capital gain you fall into when you book profit in any of your investments i.e. Short Term Capital Gain (STCG) and Long Term Capital Gain (LTCG).
Short Term Capital Gain (STCG)
When you book profit by selling your debt funds within three years of investment then it falls under Short Term Capital Gain. All short term capital gains then add to your gross income and taxes will be applicable based on your income tax slab as defined by the Income-tax department of India.
Long Term Capital Gain (LTCG)
As I mentioned before, Debt Funds returns get the benefit of indexation on long term capital gain, let’s see how it works with an example
Let’s assume, you have made an investment of INR 1,00,000 on 1st April 2015 and CII i.e. Cost Inflation Index value of the financial year 2015-16 was 254.
Your debt fund got matured on 1st April 2019 and the CII value of the financial year 2019-20 was 289. Your annualized rate of return was 8% which makes your maturity amount INR 1,36,048.90.
Your taxable return will be INR 36,048.9 without applying indexation since it is falling under long term capital gain, the Indexation will be applicable on the investment amount.
As per the formula, after diving the CII value at the time of maturity from the CII value at the time of investment you get the value (289/254) = 1.1378.
Now, after multiplying the resulted value with the initial investment, you will get the Inflation Adjusted Investment Amount i.e. (1.1378 * 100000) = INR 1,13,780.
After applying the indexation, your taxable profit will become (1,36,048.90 – 1,13,780) = INR 22,268.9, and your income tax on debt fund return will be INR 4,453.78 when you apply 20% flat tax.
Indexation benefit reduces the taxable profit by INR 13,780 in this scenario.
Debt Funds tend to perform better if the inflation is increasing year on year.
I hope, I was able to explain, how the debt fund taxation works. Let’s see the simple comparison between the returns from FD and Debt fund. Both invested at the same time and the same rate of return.
There is no much difference if you are falling into a 5% tax slab but you can save good money if you are falling into 20% or 30% tax slabs. You can access this excel file and compare the benefits by yourself.
- Top 5 Benefits Of Debt Funds You Must Know
- Why Debt Funds Are Better Than FD
- Is FD Worth Investing In 2020?
Debt Funds are considered as safe in profitable investments. It might not generate higher investment but generates steady and consistent returns in the long term. However, one should select the correct fund based on his/her investment goals and consult with their financial advisor whenever necessary. It is advisable to invest some time on analyzing the selected funds and understand at least following before investing;
- Where these funds are investing and how they have diversified their investment?
- How’d the credit rating of the bonds in which funds have invested?
- How was the past performance and returns in the long run?
- Understand your investment goals and invest only in bonds which suits it.
I hope, you found this article satisfactory and it will help you to calculate the taxes on your debt fund returns in the future. Do let me know if you have any questions or clarification.