How to control tax outgo and enhance returns on your investments

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Published: December 16, 2019 12:58:47 PM

Apart from falling interest rates on fixed deposit (FD), tax outgo on interest earned on the investments every year adds to the worry of the investors.

fixed-income instruments, fixed deposit, FD, public provident fund, PPF, tax-free bonds, FD interest, tax on FD interest, debt mututal fund, MF, beft funds, long-term capital gain, LTCG, short-term capital gain, STCG, capital gain taxIn case the fixed-income investors try to minimise the tax outgo, they may have to forgo liquidity, which may not be possible for everyone.

Apart from falling interest rates on fixed deposit (FD), tax outgo on interest earned on the investments every year adds to the worry of the investors, especially those who are risk-averse investors and believe in investing in fixed-income instruments. Although senior citizens needn’t pay tax on interest earned on bank and post office time deposits up to Rs 50,000, the entire interest on such deposits are taxable. So, the tax outgo makes the low return even lower.

In case the fixed-income investors try to minimise the tax outgo, they may have to forgo liquidity, which may not be possible for everyone. For example, PPF is a tax-free fixed-income investment option, but the maturity period is 15 years, with loan facility available from 3rd year and partial withdrawal option from 7th year. So, PPF may be used for long-term investment purposes, like to generate corpus for retirement, child education, marriage etc, but not for regular investments.

To minimise tax outgo one of the options is investing in tax-free bonds. But the rate of return on tax-free bonds will be lower than that of a taxable bond with similar credit rating and maturity period. So, such tax-free bonds may be beneficial for people in high tax bracket and may not be beneficial for people in lower tax bracket.

Another option to earn decent return without facing volatility of the stock markets is debt mutual fund (MF). Such funds invest in fixed-income instruments of various duration and ratings, e.g. government bonds, company bonds with high as well as low credit ratings. The maturity period of such instruments may vary from overnight to a few years.

While debt MFs generate return comparable to FD interest, the attractive part is its taxation. As investment in debt funds are treated as capital investments, taxation will come into the picture only when an investor redeems the bonds. So, unlike FD investors, the debt fund investors don’t have to pay tax every year during the investment period.

Currently, if investments in debt MFs are redeemed within 3 years from the date of investment, gains on such redemptions, if any, are treated as short term capital gains (STCG). The STCG is added to the total income of an investor in the year of such gain.

So, within the first three years of redemption, the total tax outgo may be the same as that of FD investment, an investor may time the redemption, by redeeming the funds in the year, in which total taxable income is comparably low.

On the other hand, if debt MFs are redeemed after 3 years from the date of investment, the gains, if any, are treated as long-term capital gains (LTCG). The tax rate on LTCG on debt funds is 20 per cent after indexation, which lowers the tax outgo considerably.

So, to enhance returns by controlling tax outgo that too without compromising liquidity, debt fund is a good option to invest in.

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