Among other factors, taxation of gains is an important consideration in making a final investment decision. While a lot of attention is given to taxation of equity investments, are you aware that returns from your debt funds too maybe classified as capital gains?
Debt fund dividends
Dividends from debt mutual funds are not taxed when received by the investor. This means that if you receive Rs 100 as dividend either from a liquid or money market fund or a pure debt fund, it will not be taxed any further. However, the mutual fund itself has to deduct a tax known as dividend distribution tax before handing out this dividend to its investors. Effectively, the return you receive in the form of dividend has already been taxed and then paid out to you.
For individual investors, the applicable dividend distribution tax is 25%. If the mutual fund is paying you Rs 100 as dividend, it means that for the purpose of this dividend, it has to set aside (100/.75) or Rs 133.33 as distributable surplus.
Moreover, if you fall in the highest income tax bracket, there is a 12% surcharge applicable to this tax, plus 4% education cess. For those who are in the highest tax bracket, the effective tax after the above comes to 29.19% and for others it is 25.99% (not including the surcharge). In other words, if a mutual fund declares a dividend of Rs 133.33, for investors in the highest tax bracket, Rs 38.82 from this amount is paid as tax and for others it is Rs 34.66 from the above dividend.
There are two types, short term and long-term capital gains; gains on funds sold before 36 months are short term gains and anything sold after are long term gains. Short term capital gains in debt funds are taxed at the rate applicable as income tax.
Debt fund capital gains
If you invest in the growth option of a debt fund, any gains in value of your holding is classified as capital gains. There are two types, short term and long-term capital gains; gains on funds sold before 36 months are short term gains and anything sold after are long term gains. Short term capital gains in debt funds are taxed at the rate applicable as income tax. In case of long-term capital gains from debt funds, the tax rate is 20% after accounting for indexed cost of investment.
Indexed gains are calculated by inflating or increasing the cost of purchase (at least 36 months ago) by the annual rate of inflation (official index).
For example, if you invested Rs 500 in a debt fund three years ago, the indexed cost of acquisition will be higher by 10.2% as per the official cost inflation index; Rs 500 cost is inflated to Rs 551.2. Assuming annualised gains of 7% for three years, your investment will be worth Rs 612.5 today. In other words, your actual gain is Rs 112.52 and as per indexed cost of investment, long term gains are Rs 61.3 (612.5-551.2); tax at 20% is Rs 12.2.
On the other hand, Rs 100 received as dividend from a debt fund is already subject to dividend tax at source and your effective tax rate is 29.19%; Rs 100 as short-term gains from a debt fund is subject to minimum tax of 10% or Rs 10 (plus cess) and maximum tax of 30% or Rs 30 (plus cess).
Given that the purchase price is inflated, gains are lower and hence, tax to be paid as long-term capital gains is also considerably lower. Only if you pay income tax at the lowest rate of 10% is it more efficient to book short term gains in debt funds, for all others long term capital gains are the most tax efficient way to invest in debt mutual funds.