Altered Investment Opportunities Post Debt Fund Tax Reforms
As of April 1, 2023, a significant change has been introduced in the taxation of debt mutual funds. Long-term capital gains (LTCG) on debt mutual funds purchased on or after this date are no longer recognised as long-term, and all gains from such funds are treated as short-term capital gains (STCG) and taxed at the investor's applicable income tax slab rates without any indexation benefit.
For debt mutual funds purchased before April 1, 2023, the old rules still apply: if held for more than 24 months, gains are treated as LTCG and taxed at a flat 12.5% without indexation benefit; if held for 24 months or less, gains are treated as STCG and taxed at slab rates. Notably, for units purchased before April 1, 2023, the LTCG tax was previously 20% with indexation if sold before July 22, 2024, but from July 23, 2024 onward, LTCG tax is 12.5% without indexation.
The Impact of the Change
This change in taxation aligns debt mutual fund taxation closer to that of fixed deposits. For NRIs, all capital gains on debt funds (since April 1, 2023) are treated as STCG and subject to 30% TDS. In summary, from April 2023 onward, the concept of LTCG on debt mutual funds has effectively been abolished for funds purchased after that date, resulting in taxation at slab rates as short-term gains for all holding periods.
The Role of Debt Mutual Funds in Your Portfolio
Despite the change in taxation, mutual funds remain relevant for a three-year investment horizon due to their potential for better returns than fixed deposits when interest rates fall. Stable and Shield portfolios of Genius invest at least 50% in debt, maintaining flexibility and high liquidity. Shield portfolios of Genius invest at least 70% in debt funds, with the remaining in a mix of equities and gold, making it a portfolio for all seasons.
For investments less than two years, the options include fixed deposits, P2P lending, and arbitrage funds. Arbitrage funds serve as a replacement for money in the bank and offer tax efficiency. Arbitrage funds have had an average return of around 4.7% in the past five years. Fixed deposits offer stable and low-risk returns, with government banks offering 6.8% - 7% interest rates on their one- to two-year FDs.
The Advantages of Mutual Funds
Mutual funds offer the flexibility to diversify across different assets, reduce risks, and optimise returns, making them a great product for a portfolio approach to investing. Public Provident Fund offers guaranteed returns, tax benefits, and historically interest rates either better than or at par with long-term fixed deposits, but with a maximum investment of Rs 1.5 lakh.
P2P lending is regulated by the RBI, but it's riskier than FDs and should constitute only 10% - 20% of a debt portfolio. Bajaj Finance's two-year FD is rated FAAA by CRISIL, indicating the best safety standards and lowest risk. P2P lending offers returns up to 10.4% for a two-year investment, with investments spread among 100-400 verified and creditworthy borrowers.
A Word on Traditional Insurance Plans
Traditional insurance plans could be a worthwhile option for a long-term investment, provided they offer close to G-sec returns, XIRR is understood, and the returns at the end of the tenure are tax-free. However, the recent changes in debt mutual fund taxation might make mutual funds a more attractive option for those seeking tax-efficient, flexible, and potentially higher returns.
[1] - https://www.moneycontrol.com/news/business/personal-finance/debt-mutual-funds-long-term-capital-gains-tax-abolished-from-april-1-2023-4228961.html [2] - https://www.moneycontrol.com/news/business/personal-finance/debt-mutual-funds-long-term-capital-gains-tax-abolished-from-april-1-2023-4228961.html [3] - https://www.livemint.com/money/personal-finance/debt-mutual-fund-long-term-capital-gains-tax-abolished-from-april-1-2023-11650913163257.html [5] - https://www.financialexpress.com/money/mutual-funds/debt-mutual-funds-long-term-capital-gains-tax-abolished-from-april-1-2023/2526346/
- The revised taxation of debt mutual funds as of April 1, 2023, removes the recognition of long-term capital gains, implying all gains are now taxed at short-term capital gains rates.
- For debt mutual funds purchased before April 1, 2023, gains held for more than 24 months are still treated as long-term capital gains and taxed at a flat 12.5% without indexation benefit, while gains held for 24 months or less continue to be short-term capital gains, subject to income tax slab rates.
- For NRIs investing in debt mutual funds after April 1, 2023, all capital gains are taxed as short-term capital gains and subject to 30% TDS.
- In contrast to fixed deposits, mutual funds provide greater returns potential for a three-year investment horizon, especially in Stable and Shield portfolios of Genius that invest at least 50% in debt funds.
- As a result of the change in debt mutual fund taxation, traditional insurance plans offering close to G-sec returns might now become less attractive compared to mutual funds due to their potential for higher returns and tax efficiency.
