How Are Debt Mutual Funds Taxed - A Complete Guide

Watching the NAV skyrocket and earning a lot of profits on your mutual fund investments surely feels euphoric until the obvious strikes you during redemption - you got to give away a part of it as taxes. (Ouch!)

With Equity Mutual Funds, you still could dodge some of the tax burden (Flat 1 lakh rupees exemption is given every year) if you had been holding the units for more than a year. But when it comes to Debt Oriented Mutual Funds, there really is no way around it. That does not mean you cannot strategise your redemptions to dial down the taxes a few notches and optimise your overall returns.

We are here to decode the tax implications and help you make wise choices.

But before that, you must be certain that what you are holding is indeed a Debt Mutual Fund.

What qualifies as a Debt Oriented Mutual Fund?

Most often, the term 'Debt Fund' would be written in the title of the scheme itself. Yet in the case of some schemes, including the hybrid ones, it might not be so obvious. In any case, the sure-shot way to find out if your investment is a Debt Mutual Fund is to check the fund's holdings.

If the portfolio of the fund predominately consists of holdings in fixed income securities like corporate and government bonds, treasury bills, debt instruments and money market securities, it is a Debt Fund. In most digital trading platforms, you will also be given a graphical representation of your scheme's asset allocation in terms of debt and equity. A hybrid fund would qualify as a Debt Fund if the fund manager has invested more than 65% of the total assets in the debt instruments that we just mentioned above. 

How are these Debt Funds taxed?

You can earn up to two types of incomes on your Debt Mutual Fund investments depending on the plan you've chosen - Growth or Dividend. Let's delve into each type of income and its taxation.

Taxation of dividend income 

For mutual fund dividends, the taxation is the same for both debt and equity funds. It is simply clubbed with your other income sources and taxed according to the income tax bracket or slab applicable to you.

For example, if you are paying 30% tax on your salary or business income, this dividend income will also attract the same rate. Then again, you could also be someone whose income is below the basic exemption limit, in which case you would not have to shell out any tax money at all. 

A TDS of 10% of the dividend payout will always be deducted if you are receiving in excess of Rs. 5000 in a financial year. Like always, you can claim it against your tax liability during your income tax assessment.

Taxation on Capital Gains

Simply put, capital gains are the profits that you earn from the appreciation in the NAV of your units. Say you had bought 1000 units of a fund when the NAV was 20 per unit. And now, when you are redeeming, the NAV stands at 50 per unit. Considering there is no exit load applicable, you have gained Rs 30 for every 1000 units, and your capital gains add up to 30,000 for the financial year.

Again this capital gain can be long term or short term depending on the time difference of purchase and redemption of units.

Tax On Short Term Capital Gains

Akin to the dividend income, the gains on debt mutual funds units, when sold before 3 years from the initial investment date (STCG), would be classically taxed with your total income. That means you pay taxes as per your applicable slab rate. 

We can say it is beneficial to liquidate your funds before 3 years if you fall in the lower tax slabs or are exempted from income tax altogether.

Tax on Long Term Capital Gains

A longer holding period, as illustrated above, would attract a tax of flat 20% on your gains irrespective of which income tax slab you fall into. To your relief, though, here you can enjoy indexation benefit to calculate your capital gains.

Suppose you had invested when the units were priced at Rs. 100, and you are redeeming them after 10 years when the NAV is Rs. 200. Instead of calculating your gains at Rs. 100 per unit, the purchase price would be adjusted till the year of redemption (of course, that 100 rupee is worth a lot more now!) and revalued as per the CPI Index released by the tax department. This will bring down your profit on paper and consequently the taxes.

Setting off Capital Losses with Gains

In case if you have suffered a loss in one scheme, you can even set it off with the gains from another scheme or any other asset. Such losses or any excess remaining after setting off, can also be carried forward for 8 assessment years to be further set off against gains, provided you file your return within the due date. 

This comes with the catch that you can't set off long term capital loss with short term capital gains. 

Nevertheless, tactfully timing your redemptions to cancel out some profits with the eligible losses can go a long way to ease your tax burdens.

Debt Mutual Fund taxation might discourage you from considering them as a lucrative investment mode, but they are proven to protect your capital and give you stable, consistent returns in the long term. Your total investment portfolio should ideally have a proper allocation between debt and equity assets to bring down the volatility in returns.