Understanding Taxation in Debt Mutual Funds

Taxation plays a key role in deciding what returns you will earn from your investment. For an individual in highest tax slab the return of 9% drops down to around 6% if the returns are taxable at maximum marginal rate. Considering inflation of 6%, the money may not be growing at all.

Debt Mutual Funds have a differential tax treatment as compared to equity. While Dividends enjoy a tax free status in equity they are taxed in debt funds through Dividend Distribution Tax. Similarly, there is no tax on long term capital gains in equity while same is taxed in debt mutual funds.  The tax rates also vary within various categories of this avenue. Hence, one needs to understand the taxations structure in debt mutual funds before making a decision to invest.

Let's analyze how investment in debt mutual funds will be taxed for FY 2012-2013.

Dividend: Dividend income is tax free in the hand of investors. However, the mutual fund company has to pay a dividend distribution tax (DDT) before distributing this income to its investors.

Tax rates for dividend income for FY 2012-2013

 

 

 

 

*5% surcharge Is applicable when total income exceed Rs 1 cr 

Capital Gains: Gains from debt mutual funds schemes are treated as capital gains. If you have held your investment for less than a year then you will have to pay short term capital gains tax while any investment which is held for more than a year is treated as long term.

Following is the tax rates for long and short term capital gains:

Long Term Capital Gains

 

 

 

 

*5% surcharge is applicable when total income exceed Rs 1 cr  

Short Term Capital Gains

 

 

 

*5% surcharge is applicable when total income exceed Rs 1 cr 

Although NRIs have similar taxation rates as resident individual, they have to pay the tax during the redemption from mutual funds scheme in the form of TDS.

For NRIs

TDS on short term capital gains: 30.900%

TDS on long term capital gains: 20.600% (With benefit of indexation)

If the actual taxation is lower, NRIs can claim the refund through filing Income Tax Returns.

How to derive benefit from investing in debt funds?

Although debt mutual funds carry higher taxation rates, one needs to select options wisely to derive the tax efficiency from the investment. When you have a short term horizon i.e. less than a year, you invest in ultra-short term or short term debt funds. Any withdrawal before one year gets taxed at your income tax slab. If you opt for a dividend option your capital gains are minimized and you end up paying lower tax on your profits in the form of DDT. Similarly, for investments with more than a year horizon, indexation benefit helps in enhancing your post tax returns.

Traditional avenues like fixed deposits, post office time deposit or NSC although give high fixed  rate of interest, they lose the benefit on post-tax returns as the income derived from these instruments is taxable at your income tax slab with no benefit of indexation in the long term. For individuals in highest tax slab, the post-tax returns are highly unattractive. Debt mutual funds with their tax efficient structure and various categories of schemes are a good option for meeting various needs.