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Dec 31, 2013, 01.54 PM | Source: CNBC-TV18

Invest in debt funds for tax efficient returns

Debt funds are often ignored in favour of equity mutual funds. But of late, a lot of people are moving towards debt as well because they see it a little more as a safe risk option. Uday Dhoot of International Money Matters explains that debt funds, typically, would give you safety along with some amount of regular dividends.

Debt funds are often ignored in favour of equity mutual funds. But of late, a lot of people are moving towards debt as well because they see it a little more as a safe risk option. Uday Dhoot of International Money Matters explains that debt funds, typically, would give you safety along with some amount of regular dividends.

dividend income is subject to dividend distribution tax but is tax free in the hands of the investors. When it comes to capital gains that you create from a debt mutual fund, a short term period, which is basically anything less than 12 months, you end up paying taxes as per your tax bracket. But if it is a long term debt fund, you have to either pay 10% or 20% tax. If you do not take indexation benefit, you just pay 10% tax. Typically, you would see that if somebody is looking at investment horizon of more than 12 months and he is taxed at the highest tax slab, you will possibly get more tax efficient returns from a debt mutual fund as compared to corporate FDs and bank FDs,” he said.

Below is the verbatim transcript of the interview

Q: Could you provide us the difference between debt mutual funds and corporate FDs or bank FDs, and in general, what the tax implications are of a debt mutual fund?

A: Debt, itself, has two types of uses in a portfolio. There is a temporary as well as permanent use of debt in a portfolio. What are these temporary uses that you can use debt funds for? Let’s say you have some funds, which are available for a very short period of time. Suppose you get a bonus and you have an insurance payment due three months down the line. What would you do with these funds for the next three months? If you leave it in the savings bank account, you will earn just 4-5 percent interest and pay tax on that. Possibly what you could do is, you could move these funds into a liquid fund in a mutual fund and possibly earn a slightly better return.

When I say it also has a permanent use, which is when people have goals. A portfolio has to be built to fulfill certain financial goals that you have set. When you have goals linked to safety of your principle, which are linked to earning regular interest then you like to have funds, which give you that safety. Debt funds, typically, would give you that kind of safety with some amount of regular dividends.

In terms of taxation, we understand fixed deposit interest income is actually taxed as income from other sources. If you belong to the 30 percent tax bracket, you pay a 30 percent tax on your income. So, let’s say if you did a 10 percent FD, you have to pay a 30 percent tax. So what you get after tax is 7 percent. But in the debt mutual funds category, there are two types of income that you can generate. You can generate a dividend income and a capital gains one.

Dividend income is subject to dividend distribution tax but is tax free in the hands of the investors. When it comes to capital gains that you create from a debt mutual fund, a short term period, which is basically anything less than 12 months, you end up paying taxes as per your tax bracket. But if it is a long term debt fund, you have to either pay 10 percent or 20 percent tax. If you do not take indexation benefit, you just pay 10 percent tax.

Typically, you would see that if somebody is looking at investment horizon of more than 12 months and he is taxed at the highest tax slab, you will possibly get more tax efficient returns from a debt mutual fund as compared to corporate FDs and bank FDs.

Q: When will you indicate that you are going for indexation benefit? At what time should the investor indicate that he wants to take indexation benefit?

A: The indexation benefit is something that the investor needs to indicate only while he is filing his returns, where the tax department has given fair amount of levy. For every single transaction you can decide whether you want to take indexation benefit or no. Let’s assume that you have invested Rs 5 lakh in a debt fund in two tranches of Rs 2.5 lakh and Rs 2.5 lakh. You may choose to take indexation benefit in one while you may chose not take indexation benefit in the other, it completely depends on what is more beneficial for you.

Q: You also spoke about that for a longer term if an investor is in the higher tax bracket, it’s perhaps more tax efficient to go in for debt mutual funds over banks. For a shorter term, which is sub-12 months which one makes more sense?

A: In the shorter term, the capital gains tax is the same for both interest income as well as your capital gain income. When you go into a debt mutual fund, you can take a dividend option. Dividends are subject to dividend distribution tax so there is tax efficiency is not as high in the long term. You still have tax efficiency coming to debt mutual funds in the short run. Secondly, debt mutual funds typically also generate possibly higher returns as compared to some of the short term FDs.

Today, one year FD gives 9 percent but a six-month or a nine-month FD gives you just 7 per cent returns. So, if you look at a shorter term funds, you may possibly get not only better returns as compared to your FDs but there may be slight tax efficiency.

Q: An investor is 65 year old. She and her husband are retirees. She wants to know what are the low-risk investment options she can choose from?

A: They are both retired and are looking at some safe investment options for the retirement corpus. I can think of two basic requirements that they will have. One is to ensure that they get some sort of a regular income from this fund that they will invest so that their regular needs are taken care of. Possibly, just in case there are any medical emergencies, they would like to have the access to their funds or their investments. I would like to possibly look at these two things and suggest them the options accordingly.

We have different categories of mutual funds. We have something called a liquid fund, which is almost like your bank account. You can invest and withdraw money at your convenience. There are no lock-ins, no entry loads and no exit costs as such. For the emergency fund that they would like to keep, I would suggest them to invest that money in a liquid fund.

Given the market environment today, we expect that the rates to start coming down on the longer tenure. They should have some of their investments in slightly longer duration funds, but a debt portfolio. They can look at funds, which will give them not only a regular interest, but in case the interest rates go down, possibly some amount of capital appreciation as well. So these are the two type of funds that they can look at. So, they should look at liquid funds for the emergency corpus and for the long-term debt or medium-term debt for their regular return requirements.

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