In recent years, the Government has announced major amendments to the debt mutual funds taxation system. These new rules, introduced and implemented in 2023 and 2024 have changed the way capital gains from debt mutual funds are taxed, and have had a significant impact on investors. The indexation benefit on LTCG tax has been eliminated, and all profits from investments made after 31 March 2023 are taxed according to the investor’s tax slab rates.
Here, we’ll take you through these changes, understanding how income tax on debt mutual funds is levied, and how the new rules have impacted investors.
What are Debt Mutual Funds?
Debt funds are types of mutual funds which invest mainly in fixed-income securities such as government bonds, corporate bonds, treasury bills, and other money market instruments like certificates of deposit and commercial papers. Primarily, these kinds of funds generate returns through interest, though they can also do so through capital appreciation.
For debt mutual funds taxation purposes, it must be stated that such funds invest less than 35% of their assets in equities. Therefore debt funds are preferred by conservative investors looking to preserve the value of their capital or generate stable returns, as the volatility compared to equity funds is much lower.
Types of Debt Mutual Funds
Depending on the time horizon and the securities they invest in, debt funds can be categorised into many types, such as:
- Liquid funds – As the name suggests, these funds offer high liquidity by investing in securities that mature within 91 days.
- Overnight funds – Mature in just a single day.
- Ultra-short duration funds – Invest in securities that mature in 3 to 6 months.
- Short-duration funds – Have a longer investment horizon as they invest in securities that mature in 1 to 3 years.
- Medium duration funds – Underlying securities mature in 3 to 4 years.
- Long-duration funds – Come with a very long maturity period of over 7 years.
- Gilt funds – Invest only in Government securities of varying maturities. The credit risk in these funds is minimal.
- Corporate bond funds/ Banking and PSU funds – Invest mainly in corporate bonds and debt securities offered by banks, PFIs, and PSUs.
Debt Mutual Funds Taxation Before and After April 1, 2023
With Budget 2023, the Government significantly changed how the tax on debt funds is levied.
Before April 1, 2023
According to the old rules, the debt mutual funds taxation system worked according to the investment’s holding period. Capital gains were deemed long-term if the debt fund’s units were held for at least 36 months before redemption, and an LTCG tax was levied. Profits from investments sold within 36 months of purchase were considered short-term gains, and an STCG tax was charged on them.
1. LTCG Tax:
Long-term capital gains were taxed at 20% with an indexation benefit. This means the purchase price of the investment is adjusted for inflation using the Cost Inflation Index, which ultimately reduces taxable capital gains.
2. STCG Tax:
If the debt fund’s units were sold within 36 months of purchase, gains were added to the investor’s income and taxed according to the slab rate.
3. Budget 2024 update:
A new rule was introduced by the Government, according to which debt fund investments made on or before 31 March 2023 and redeemed on or after 23 July 2024 attract a 12.5% LTCG tax without indexation benefit. For gains to be considered long-term, the holding period has been reduced from 36 months to 24 months (for unlisted securities) or 12 months (for listed securities).
This move was made to bring uniformity across different types of investments. Since the tax landscape is constantly evolving, investors can benefit greatly by seeking professional tax consultation services to optimise their investment strategies.
After April 1, 2023
Debt fund investments made after 1 April 2023 are not taxed according to the investment’s holding period. Long-term capital gains no longer enjoy the debt mutual funds indexation benefit, and just like short-term gains, they are taxed as per the taxpayer’s income tax slab rate.
While this move has helped individuals in the lower tax brackets reduce their tax burden, investors belonging to the higher slabs have been negatively impacted.
Impact of Taxation Changes on Debt Fund Investors
Due to the removal of the debt mutual funds indexation benefit, the LTCG tax advantage has been eliminated. Debt funds have thus been made less tax-efficient than they were before. Earlier, investors could use indexation to adjust the purchase price for inflation and lower their tax burden.
Now, all investments made after 31 March 2023 are taxed according to the investor’s slab rate. Investments made before 31 March 2023 and sold after 23 July 2024 attract a 12.5% tax without indexation, provided the investment is sold after being held for 24 months.
Thus, investors in the higher tax brackets have been negatively impacted, while there is some relief for those in the lower brackets. A tax consultant can help investors minimise the impact of these changes by creating investment strategies aligned with their client’s financial goals and risk tolerance. They can also structure withdrawals in tax-efficient ways and recommend SWPs spread out redemptions and lower one’s tax liability.
Comparison: Debt Mutual Funds vs Fixed Deposits Taxation
Another popular investment option among conservative investors is fixed deposits. These vehicles are also known for their capital protection and predictable returns. Let’s have a look at how FDs differ from debt mutual funds.
| Factor | Debt Mutual Funds | Fixed Deposits |
| Returns | Debt fund returns are market-linked and generally higher than those offered by FDs. | Fixed deposits offer a fixed interest at regular intervals. |
| Liquidity | Debt funds offer high liquidity. Funds like overnight funds invest in securities that mature in 1 day. | Fixed deposits have long lock-in periods, thus their liquidity is much lower. |
| Risk | Credit and interest rate risk are generally the major risks associated with debt funds. In general, the risk associated with them is quite low due to their underlying securities, diversification, and professional management. | Fixed deposits are very low-risk vehicles backed by banks and NBFCs. |
| Lock-in Period | While they don’t have lock-in periods, some debt funds impose exit loads in order to prevent investors from backing out early. In the vast majority of cases, these exit loads are very low and applicable only for a short duration. | Lock-in periods for FDs can be long, during which withdrawals may not be possible or may attract penalties. |
| Type of Income | Capital gains and dividends. | Interest. |
| Tax | Gains made from investments made after 31 March 2023 are added to the investor’s income and taxed as per their slab rate. Dividends also attract income tax on debt mutual funds. They are added to the investor’s income and taxed according to the slab rate. | Interest earned from FDs is also taxed according to the investor’s slab rate. |
| When is Tax Paid? | Capital gains tax is paid only when units are sold or redeemed. | Interest earned from FD is taxed every financial year. |
| Indexation Benefit | No | No |
| Tax Deducted at Source | No TDS tax on debt funds is deducted by the mutual fund house on capital gains. However, dividend income from mutual funds is subject to TDS if it exceeds a specified threshold (10% TDS on dividend income of more than Rs. 5,000 per year) | Interest above Rs. 40,000 in a financial year attracts a TDS of 10% (the threshold is Rs. 50,000 for senior citizens) |
Their liquidity, flexibility in redemption timing, and higher returns give debt mutual funds the edge over fixed deposits. A mutual fund planner can help investors choose the right debt fund based on risk tolerance, financial goals, and investment horizon.
Strategies to Minimize Tax on Debt Mutual Funds
Now that you are aware of the workings of the debt funds india taxation system and the impact of its recent changes, have a look at some ways to save tax on debt fund profits.
1. Holding Debt Funds in Lower Tax Bracket Years
Since the income tax on debt mutual funds depends on one’s tax slab rate, redeeming investments during a lower-income year can reduce overall tax liability.
2. Investing in Hybrid or Dynamic Funds
If a mutual fund invests more than 65% of its assets in equities, it is taxed as an equity fund. Such funds have different taxation rules. If the units are sold or redeemed within one year of purchase, STCG is levied at 20%. On the other hand, gains made on equity fund investments held for over a year attract a lower tax rate, an LTCG of 12.5%. Additionally, there is a Rs. 1.25 lakh exemption on capital gains from equity instruments which leads to further tax savings.
A hybrid fund is a mix of debt and equity funds, and its tax treatment depends on the mix of assets held in its portfolio. Of course, the risk associated with equity funds is much higher, so they may not be suitable for conservative investors.
Those looking for better tax efficiency can consider investing in equity-oriented hybrid funds. Consulting a mutual fund investment planner could be wise as they can assess your risk tolerance and financial goals to advise you on what kind of investment would be best for your circumstances.
3. Opting for Systematic Withdrawal Plans (SWP)
A Systematic Withdrawal Plan prevents investors from redeeming the entire maturity amount at once by structuring withdrawals over a period. Profits spread out over multiple years can keep the tax rate lower.
4. Considering Direct Bond Investments
Investors looking for greater tax efficiency can consider investing directly in bonds, CDs, CPs, and T-bills. However, managing these securities individually can be tedious, and one can miss out on debt mutual fund benefits like diversification, (which helps mitigate risks like credit risk) convenience, and higher liquidity.
Conclusion
The changes made in 2023 have effectively eliminated an investment’s holding period as a factor when determining the tax treatment of debt fund gains. There is no longer any debt mutual funds indexation benefit on offer for LTCG. Now, the profits made from debt fund investments are taxed according to the investor’s slab rate. For those who made their investment before 31 March 2023 and are redeeming it after 23 July 2024, the gains will be taxed at a flat 12.5% rate without indexation benefits, provided the investment is held for at least 2 years.
These changes mean that debt mutual funds taxation is now similar to how FD interest is taxed (Not taking into account dividends and TDS). However, since gains are only taxed when units are sold, debt funds provide some relief in tax timing over FDs, where tax is paid every year on interest earned. Coupled with their potential for higher returns and much higher liquidity, debt funds still offer many advantages over FDs.
