The Impact Of The Debt Funds Taxation Change From 1st April 2023 (FY2023-24)

The budget for FY2023-24 will bring changes to the taxation of debt funds. Understanding the impact of these changes is crucial. In this blog post, we will examine how the taxation of debt funds will change on April 1st, 2023, and how financial planning can assist you in achieving actual returns and personal objectives. Continue reading to learn more about the taxation changes and how to maximize their advantages.

Taxation Of Debt Funds Changing On April 1st, 2023

Are you holding debt funds in your investment portfolio? If so, it’s important to know that the taxation of debt mutual funds will change from April 1st, 2023. This change, announced in the Budget 2021, is likely to significantly impact the way investors approach their investments.

Under the new rule, capital gains will be taxed as per an investor’s income tax slab rate, regardless of the holding period. Prior to this decision, Short term Capital Gains (STCG) on investments held for less than 3 years or 36 months were taxed as per their income tax slab rate, whereas Long Term Capital Gains (LTCG) on investments held for over 3 years or 36 months were taxed at a flat rate of 20% with indexation benefits.

This new rule may steer investors away from debt funds and towards other alternatives, such as bank fixed deposits, which hold similar interest rates but are not subject to these changes. Asset Management Companies may reconsider changing mandates to increase equity exposure in order to make debt funds eligible for the old taxation methods via arbitrage routes.

Existing debt fund investments made prior to March 31st, 2023 will still benefit from LTCG & indexation benefits when redeemed after April 1st, 2023. This could be beneficial if you have invested in long-term capital gain instruments such as gilt funds and corporate bond funds prior to this date.

It’s important for investors to understand how these changes will affect their portfolios and to plan accordingly before deciding regarding their finances or investments for FY 2022-2023.

Recent changes in taxation rules regarding debt funds have a significant impact on your finances, if not planned correctly beforehand.

Your Strategy To Ensure That Your Tax Outflow Does Not Hurt You Much Can Broadly Be As Follows:

• You will need to plan your redemptions, especially for long-term goals, a bit more carefully to ensure your tax outgo is contained in a particular year. The dipstick test is to see if by adding your capital gain, you remain in the same slab or jump to the next slab. Phased redemptions will become necessary before major goals. 
• Tax harvesting, by periodically booking profits and re-entering again right away, may become necessary to ensure your gains are not too high that can push you to higher tax slabs. This is less of a necessity for those already in the highest tax slab and more applicable for those in the lower and middle slabs. Since you do not get the indexation benefit (which boosts your cost), the only other option is to exit and re-enter at a higher cost, thereby inflating the cost for tax purpose for yourself. For example, if you invested at Rs 5 NAV and sold at Rs 7, you get taxed on Rs 2. And when you re-enter at Rs 7 immediately, the cost for tax purpose is Rs 7. So, you have inflated your cost for future tax calculation, although your original investment was at Rs 5. 

Second, let’s take up the debate on the parity in taxation of fixed deposits and debt funds and whether FDs make more sense now. From merely a tax perspective (and not on other counts), we don’t think FDs are better off because:

1. With FDs, you lose tax every year, even when you hold a cumulative deposit as it is taxed on accrual. With mutual funds, you are taxed only on redemption. The time value of money, by delaying tax outflows, act in your favour. There is also no TDS with debt funds.
2. Although some of the categories of funds have lost their long-term status, they are still considered capital gains. Which means the short-term capital gain can be set off against any short-term capital loss. This is not a benefit available with FD interest.
3. Systematic withdrawal plan, even after the tax change, will remain beneficial because of the way it is taxed. For example, if you are deriving Rs 50,000 per month of interest income from your bank, the same is fully taxed. However, if you do a SWP of Rs 50,000 per month, then only the gain component is taxed. This could be very low in the initial years (higher principal) and slowly grow in later years. Even so, the entire withdrawal is not taxed. This gives SWP an advantage over interest income.

Besides the above tax reasons, the liquidity that debt funds provide is unmatched. Yes, like before, you can and should always look at FD options that offer attractive interest.