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Understanding tax implications of debt funds

Taxation eats up real returns. "Post tax returns" plays a very pivotal role if one consider debt mutual fund. Read this space to understand the impact of taxation on debt funds.
Jul 24, 2013 / 05:22 PM IST

The first and important factor while investing in debt funds is one should always look at “post tax returns” while investing in debt products, else you would be comparing apples with oranges.

Also Read: Taxation on debt mutual funds

As for debt products, post tax returns give a more realistic picture rather than pre-tax returns. The table below shows the pre and post tax comparison for Tax Free Bonds vs Fixed Deposits for an individual and how the tax slabs play a role in the decision:

Investment AvenuesTax Free BondsFixed Deposits
Marginal Tax SlabNA10.00%20.00%30.00%
Pre Tax returns7.20%9.00%9.00%9.00%
Interest RatePost taxPre taxPre taxPre tax
Effective Post tax rate7.20%8.10%7.20%6.30%

The first important point is that one should consider the Marginal tax slab. What we mean by marginal tax slab is the last bracket in which you pay the tax. For example if your annual income is Rs. 13 lakhs your marginal tax rate would be 30% and if your annual income is Rs. 8 lakhs your marginal tax rate would be 20%. A person falling in 0-10% tax bracket is better off by investing in fixed deposits where he will get higher returns as compared to tax free bonds as the effective post-tax returns are higher. A person in the 20% tax bracket is indifferent as he would get the same returns in either of the investment. Whereas a person in the 30% tax bracket should opt for tax free bonds as compared to fixed deposits as he would get higher returns by investing in these bonds.

Thus, any investor who falls in the tax slab of more than 30% needs to be extremely conscious of the post tax return as it significant factor in the decision.

Now,  if an investor wants to invest in debt mutual funds then one more important factor he needs to check is that which option he wants to opt for “growth” or “dividend”.

Normally, if you need regular income, you would opt for Dividend Payout as an option and Growth if you do not need regular income.

Dividends from a mutual fund are not taxed in the hands of the investor. However, the fund pays a dividend distribution tax (DDT), which is indirectly recovered by the fund from the NAV.

The table below shows the gain/loss the person incurs if he opts for dividend payout option:

Tax Bracket10.00%20.00%30.00%
Effective DDT22.07%22.07%22.07%

Thus a person who falls in the tax bracket of 10% and 20% stands to lose if he opts for dividend payout option whereas a person in the tax bracket of 30% is still benefited by opting for the same.

If you are looking at a long-term investment option and if you are not interested in returns at regular intervals, then you can opt for growth option. In the growth option, the capital gains are taxable in the hands of the investor. For more details on capital gains check out our previous article Taxation of Debt Funds.

The table below shows the gain/loss the person incurs if he has opted for growth option assuming he does not require regular income.

Tax Bracket10.00%20.00%30.00%
Tax on capital gains*10.00%10.00%10.00%

*Taxation is 10% of gain without indexation or 20% of gain with indexation whichever is less. For calculation we have assumed a worst case scenario of taxation of 10% even though the actual tax could be lesser.

A person who falls in the tax bracket of 10% would be indifferent and hence all individuals should ideally opt for growth option if they do not need regular income. Thus an investor who invests in debt funds should first look at post tax returns and then carefully choose his investment option.

Based on the above, we have made an investment matrix for any easy understanding for investors, which is given below:

Income Requirement                Income Tax Slabs
Require Regular IncomeShort TermTaxable instruments (NCDs/Bonds/Fixed Deposits)Tax Free Bonds/Debt Funds (Dividend Payout)
Long Term
Do not Require Regular IncomeShort TermDebt Funds (Growth)Debt Funds (Dividend Reinvest)
Long TermTax Free Bonds/Debt Funds (Growth)

- Juzer Gabajiwala
The author is the Director of Ventura Securities

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