Tax-free returns from indexation in debt funds

Written by Anil Rego | Updated: Oct 23 2012, 09:15am hrs
Debt mutual funds offer excellent investment opportunity to retail investors. Debt mutual fund should be considered as a part of debt investment in the portfolio as it offers multiple benefits against other avenues. The most important benefit offered by debt mutual fund is taxation. Long-term holding in debt mutual fund is very tax-efficient.

How do you feel if you have made a profit on your investment, but do not have to pay tax on it or the tax payable is only on the partial profit made from the investment You may want to know how this could be possible.

Long-term capital gain on debt mutual fund offers indexation benefit. If you invest in the debt mutual funds and the holding period is more than a year, the income from it will be treated as long-term capital gain. It will be taxed at 10%, or 20% with indexation benefits.

Under indexation, the cost of investment is raised to account for inflation for the period the investment is held. Indexation gives a benefit of cost inflation index (CII), which takes into account the effect of inflation and reduces the value of gains by increasing the value of the purchase amount. This helps reduce the tax amount. It's the governments way of keeping the real value of money. The longer the holding period of debt fund, the bigger is the indexation benefit. Moreover, there is also o TDS in debt funds for resident Indians.

How indexation works

If you invested R1 lakh in debt mutual funds on October 10, 2010, and it gives returns of 9% per annum, the value will become R1.09 lakh after a year. If you redeem it on October 13, 2011, you will get the following benefits:

* Cost of inflation index for 2011-12: 785; for 2010-11: 711

* The cost of investment (with indexation) is equal to R1,00,000 x 785/711 = R1,10,408

* Redemption value after 1 year = R1,09,000

* Long term capital gain/loss = R-1,408 (R1,09,000 R1,10,408)

The above computation illustrates that there is no tax liability and there is no need to pay any tax on the gain of R9,000. Also, you can carry forward this loss of R1,408 for the next eight years to be adjusted against any long-term capital gain.

Lets compare the benefit with an investment of the same amount in a bank fix deposit. If you had invested R1 lakh in a bank fixed deposit at 9% per annum, you would be liable to pay tax as per your tax slab, that too on an annual basis. If you fall in the higher tax bracket (that is, 30%), the post-tax yield will be just 6.3% per annum.

Also you can postpone the tax liability by investing in debt funds. In debt funds, the tax is payable at the time of redemption, unlike fixed deposits where you need to declare the interest income and pay tax on it every year.

Other benefits of debt funds

Liquidity. Debt mutual funds are highly liquid and you can encash them easily. Redemption request in debt funds are processed within a day. Nowadays, some mutual funds offer ATM cards for your investment in debt liquid fund.

Flexibility in investment. Debt mutual funds are flexible than fixed deposits. Investment in debt MF is possible by away of systematic investment plans (SIPs) and withdrawal is possible through a systematic withdrawal plan. So, if you fall above the 10% tax bracket, you stand to gain by investing in debt fund.

You can consider investment in debt fund based on your risk appetite. Just like investing in a government-backed post office deposit, you can buy debt funds that invest only in government bonds.

In todays context of falling inflation and interest rates scenario, you can consider investments in debt funds. Further fall in interest rates should be helpful for debt mutual funds.

Why debt funds

* Long-term capital gain on debt mutual fund offers indexation benefit

* If you invest in the debt mutual funds and the holding period is more than a year, the income from it will be treated as long-term capital gain. It will be taxed at 10%, or 20% with indexation benefits

* Indexation gives a benefit of cost inflation index (CII), which takes into account the effect of inflation and reduces the value of gains by increasing the value of the purchase amount. This helps reduce the tax amount

* Debt mutual funds are highly liquid and you can encash them easily

The writer is CEO and founder of Right Horizons