In the article of March 9, 2020 (https://www.thehindu.com/business/Economy/some-ideas-to-make-your-mf-investments-tax-efficient/article31011110.ece), we discussed about tax efficiency in equity mutual funds. Now, we will discuss about debt mutual funds (MFs), also known as fixed income MFs.
There are two options in a fund viz. a dividend option where the MF pays dividend to you and the growth option, where there is no payout but the gains remain in the NAV and you can redeem the investment at that NAV when you want. Tax efficiency is better in the growth option, which we will discuss here.
In the dividend option, as mentioned in the Union Budget, dividends are taxable in your hands from April 1, 2020 instead of the earlier system of the MF deducting a dividend distribution tax (DDT) on your behalf and paying the government.
If you are in a lower tax slab, say 5% or 20%, the dividend option is tax efficient but most investors are in the 30% tax bracket.
In the growth option, to get the benefit of a lower tax rate, you have to hold the MF for three years. This is technically called long-term capital gains (LTCG) tax. Upon holding your debt MF units for three years, you become eligible for this levy.
Short-term gains
If you hold it for less than three years, it is short-term capital gains (STCG) taxed at your slab rate. Here again, you are better off if you are at a lower tax slab, but assuming you are in the 30% bracket, it is not very tax efficient. In the LTCG, there is a defined tax rate of 20% on the gains. But there is the benefit of ‘indexation’ by virtue of which the effective tax rate comes down significantly.
The way indexation works is like this — the tax authorities declare an index number, called cost inflation index (CII), every year. As per this, your purchase cost is ‘indexed up,’ hence, the taxable component of the gains comes down significantly.
Now, let’s see how indexation works. Let us say you invested in a debt mutual fund growth option on August 27, 2016 (or any date in financial year 2016-17) at ₹100 and redeemed it on August 27, 2019 (or any date thereafter to complete three years of holding) at ₹121. The CII for financial year 2016-17 as declared by the government is 264 and the CII for financial year 2019-20 is 289. Hence, your purchase cost gets indexed up, for tax purposes, to ₹100 x 289/264 = ₹109.47. Your taxable LTCG is ₹121 – ₹109.47 = ₹11.53. Tax at 20% (ignoring surcharge and cess for simplicity) will be ₹11.53 x 20% = ₹2.31. Thus, the effective tax rate, as a percentage of your gains, is ₹2.31 / ₹21 = 11%.
Now, let’s extend this method. You invested in a debt mutual fund on March 27, 2016 at ₹100 and redeemed it at ₹121 on April 12, 2019. Here, you get the indexation for one more financial year. The CII for 2015-16 was 254, that for 2019-20 was 289 and your indexed purchase cost is ₹100 x 289/254 = ₹113.77. Your taxable component is ₹121 – ₹113.77 = ₹7.23. The tax at 20% (ignoring surcharge and cess) is ₹7.23 X 20% = 1.45. The effective tax rate, as a percentage of your long term capital gains, is ₹1.45 /₹21 = 6.9%.
The data on CII is available through Google. To ensure you are referring at correct numbers, you may cross-check with the numbers mentioned above e.g. 289 for 2019-20. The CII for a financial year is announced sometime around August to October of the year, with reference to CPI inflation of the previous year.
To summarise, you reduce your tax in debt MFs by viz. holding the fund in growth option and for at least three years. If you invest in March and redeem in April after approximately three years, it’s even better.
You may use debt MFs after retirement, called the distribution phase of life, through a systematic withdrawal plan (SWP). That is, you would place your retirement kitty in debt MFs and do SWPs to withdraw as per your requirements every month.
To generate tax efficiency in SWP, you have to start the SWP three years after retirement. For tax purposes, to match against the exit, the NAV of your earliest investment will be considered. This is known as First In First Out (FIFO) i.e. every exit will be matched with the earliest entry in that fund.
Another point to be noted, in the context of availing indexation benefit in debt MFs, is that there is a notion among some people that the benefit of indexation is available by investing in Fixed Maturity Plans (FMPs) in March, which will mature after approximately three years in April. While this is correct and gives you the benefit of indexation across four financial years, this is true for all debt funds viz. short duration fund, long duration fund, etc.
You will invest as per your preference, but for comparison purposes, FMPs are not liquid. There is no redemption with the AMC in FMPs and though listed at the exchange, there is no liquidity. If you invest in open-ended funds i.e. the usual short duration fund or banking and PSU fund, in case you require your money, you can redeem with the AMC.
(The author is founder, wiseinvestor.in)
