Wednesday, August 7, 2013

Debt Mutual Funds and Tax Implications – Recent changes in tax rates

Earlier Bachhat had written about how one can use ultra-short term debt funds to maximize post tax returns.  The article spoke about investing in dividend reinvestment plan of such funds, since dividend are effectively taxed at lower rate than short term capital gain rates and hence such funds are tax effective.

The tax rates on debt mutual funds were revised earlier during this year and hence the said article is not relevant in the current scenario.  Based on the revised tax rates, we have tried to analyse and tabulate which type of option (growth or dividend) should be chosen for investment in debt mutual funds.

Revised tax rates on debt fund
For an individual investor, short term capital gains in a debt mutual fund is taxable at tax slab under which such individual falls.  Long term capital gains are taxable @ 20% with indexation benefit and 10% without indexation benefit.  Surcharge @ 10% for taxable income of more than Rs. 1 crore and cess @ 4% shall apply additionally.

For dividend distributed, dividend distribution tax is applicable.  Earlier there was difference in dividend distribution tax rates between liquid / money market funds and other debt funds.  Now this difference has been eliminated and now dividend distribution tax on all debt funds shall be 25% (effective tax rate of 28.325% including surcharge and cess).

Growth or Dividend Option
One can maximize his returns from debt funds by choosing the correct option which has least tax implication.  Things to be considered before choosing a plan are:
    1. Time period for investment
    2. Tax bracket under which an individual falls
    3. Need for regular income

Based on the above three criteria, the best option to choose from is as below:


When regular income is required
Since dividend distribution tax rate (28.325%) is higher than the effective tax rate for investors falling under 10% or 20% tax slab, it is beneficial for them to opt for growth option in case they are looking for investment horizon of less than 1 year and choose systematic withdrawal plan wherein a fixed amount shall be redeemed and paid to the investor at periodic interval.  SWP shall provide source of regular income to them.  However before opting for SWP under growth option, one needs to check out for exit load and commence SWP only after the exit load period. 

For individuals falling under 30% tax slab and in need of regular income, the tax benefit between dividend and growth option is minimal with dividend option slightly beneficial than the growth option.

For investment horizon of more than 1 year, it is beneficial for all investors looking for regular income to choose systematic withdrawal plan under the growth option.

When regular income is not required
For investors not looking for regular income, growth option is best irrespective of investment horizon.  However, there can be marginal tax benefit for investors falling under 30% tax slab by choosing dividend reinvestment option for investment horizon of less than 1 year.

Bachhat’s take
By increasing the dividend distribution tax rate, the tax advantage of dividend option which was available till late year has been eliminated, save for investors falling under 30% tax slab.  If an investor decides to invest in a debt mutual fund, he needs to take into consideration above aspects to increase his post-tax returns.  However one needs to keep in mind that the above analysis is relevant only till the tax rates are kept constant.  In case of any revision in tax rates (which may happen at the earliest in 2014 budget), the above may not hold true. 

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