How to deal in Debt Mutual Funds with the recent changes?

Over the years, mutual fund houses and financial advisors have been actively promoting and advising on debt mutual schemes, as a better alternative to bank fixed deposits because these were offering double indexation benefit as to be taxed at a lower rate. Apart from benefiting from indexation, debt schemes are, often invested for short-term purposes, say, 1-2 years. But, on 10^th July 2014, the maiden budget of NDA government has hammered by changing the taxability of debt schemes as the holding period of long-term debt schemes has been extended from 12 months to 36 months and creating tsunami in the minds of debt investors. Debt scheme investors who probably had to enjoy tax arbitrage in long-term capital gain i.e. 10% without indexation or 20% with indexation, whichever was lower, will, now be no longer available and they have, hence to pay a tax as high as 30% on the capital gain or 20% with indexation as the case may be. To reduce the tax liability, they would, now need to hold the investment for minimum period of three years to gain the indexation benefit.

In that scenario, millions of debt investors have been bewildering, how the new recent changes will affect them in different debt products. They are, now begging so many questions; are debt schemes still worth considering? Which ones? What kind of return they can expect? How to handle the taxation aspect? We have endeavored to address these questions in this cobra post.

Existing Debt Investments

Fixed Maturity Plans (FMPs) maturing in the next one to three years has the worst hit under the debt category. With the recent changes, the investors of FMPs who have already invested with the intention to get the benefit of double taxation would no longer be possible and would have to now pay tax as per one’s income-tax slab leads to their post-tax returns will be significantly lower. Those who have already invested in debt schemes or other non-equity schemes, like capital protection schemes or monthly income plan scheme, with an investment horizon of one year to three years, to fund certain short-term goals, they may like to opt for a rollover only if they would absolutely not require the money during extending period. Fund houses are, now offering investors in one year FMPs, the option to rollover their investment for two more years. To mitigate the tax burden, it is advisable to all FMPs’ investors should exercise the option for a rollover which cannot be redeemed before maturity. However, it must be noted here that the portfolio and expense ratio is likely to change after the maturity period.

Keeping Emergency Fund

For retail investors, liquid schemes of mutual funds are the life line for keeping in the bulk of their emergency fund to meet any unforeseen event. With the budget impact of debt mutual funds, liquid schemes are also in questioned and investors are getting confused and have been asking what they should do with their investments in such schemes. Though bank fixed deposits do provide safety and equivalent returns, they are not still an ideal choice for keeping an emergency fund in bank FDs. While dipping into your emergency fund from bank FDs, you would have to pay premature withdrawal charges in addition to the tax on interest. Ergo, it is advisable to keep invest your money as an emergency fund in liquid schemes, for the units held for more than three years, you would have to pay a tax of 20% with indexation or any partial withdrawal before three years , which will probably be much lower than of your income tax slab rate.

Another alternative, you can keep the fund in normal saving account which pays an annual interest of to the tune of 6% to 7%. As per Section 80TTA of the income tax act, saving account interest up to Rs 10,000 is not taxable, you could keep up to Rs1.60 lakh in such an account to stay away from tax liability.

Debt Fund with Dividend Plans

Dividend plans of debt schemes, which pay a monthly or quarterly dividend to their investors. The prime reason is opt to dividend option in debt schemes, to get regular income and    not paying any tax on it. Unfortunately, most investors may be unaware about the tax impact under dividend option. Even though, investors do not have to pay tax on the dividend earned, the schemes have already deducted a dividend distribution tax (DDT), at the time of payout. Dividend plans were never the best option for investors due to taxation, it has, now more badly hit with recent the budget has changed the method of calculating DDT was earlier calculated on the net amount paid; now it has to be deducted on the gross amount. Therefore, the effective tax rate will now go up to 39.52% from 28.33% which is higher than your normal income-tax rate. Thus, this option will turn out to be strongly avoidable for new and existing investors as well; hence it is advisable to transfer your existing investments to growth option while opting for systematic withdrawal plan (SWP). It would be more tax-efficient to opt for SWP and pay tax on the amount withdrawn, but only on the gain for the number of units withdrawn.

Market-linked Returns

Many investors have misconception that investing in debt mutual fund schemes is safe-haven like bank FDs. We have consistently reiterated that debt schemes are never be a ‘safe’ choice as their returns are market-linked and unpredictable like equity mutual funds. These schemes carry interest rate risk unlike bank FDs. Sometimes, their returns could be really low or even negative. On top of this, post-budget, the tax treatment of income from debt schemes, for holding less than three years would be the same as that on bank FDs. Therefore, investing in debt schemes is so cautious to get post-tax returns and take tax-advantage of indexation benefit. You should have to invest in top performing debt schemes according to your investment horizon while have some understanding of interest rate cycles. Therefore, it is important to note here that income schemes, which have a longer duration, are riskier than short-term debt schemes.

Debt Schemes worth considering

Even though, the debt schemes have lost the tax benefits they offered for period of one to three years, bank FDs are still not better bet for investors familiar with debt schemes. Bank deposits offer fixed returns and protection capital; but its accrual income is taxable every year at applicable rates. On the other hand, a little known aspect of debt mutual fund is that withdrawal of all the gains of a year are not fully treated as capital gains; turn out to be tax-efficient, provided you do not withdraw the entire corpus in less than three years. Hence, it will not be taxed, only the capital gains component of the withdrawal, unlike interest on bank fixed deposits where the full withdrawal of interest income is fully taxed.

Consider this:

*Rs 90,000 or 82.569 units (@Rs 1,090/unit); STCG = Rs 90,000-Rs82,569(82.569 x 1000 per unit) =Rs7,431

In evident above the table, for the most investors, debt schemes are still better than bank FDs, even whose investment horizon is less than three years and they can still able to take also advantage to get more post-tax return, if they have horizon exceed three years, thanks to the indexation benefit.

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