The recent amendment to the Finance Bill 2023 has leveled the playing field between fixed deposits and debt mutual funds.
In this article, let is understand the recent amendments made to the Finance Bill 2023, and how it will impact debt mutual funds.
Table of Contents
Difference between equity mutual funds and debt mutual funds
Firstly, note the difference between equity mutual funds and debt mutual funds. Equity mutual funds invest in stocks and shares, while debt mutual funds invest in bonds and securities.
Amendment to Finance Bill
The first key amendment to the Finance Bill is related to mutual funds, where mutual funds with less than 35% AUM in domestic equity will lose indexation benefits. Indexation benefits refer to the rate of inflation or average rate of inflation over the last three years, which is used to calculate the taxes payable on the profits made from investments in debt mutual funds.
Taxation
Earlier, Debt MF investments held for more than 3 years were taxed at 20% with indexation benefit. This indexation helped the investors in bringing down their tax outgo. If there is higher inflation during this investment period, the net tax outgo used to further go down. Indexation has been a very good tool to minimize taxes and thus maximize the returns from Debt MFs. Let us understand this indexation benefit with an example.
Prior to the said Finance bill amendment, the debt MFs held for more than 3 years were considered long-term investments and are taxed at 20% with indexation benefit. The long-term capital gains tax rate of 10% will be applicable if the investor chooses not to avail the indexation benefit.
Example
If an individual invests Rs. 100,000 in debt mutual funds and assumes a growth rate of 10%, their total profit after three years would be Rs. 30,000. Assuming an average inflation rate of 7%, the net growth rate would be 3% after adjusting for inflation (10% minus 7%).
With indexation benefit, the tax would only be 30000 X 3% X 20% = Rs.1,800. Without indexation benefit, @10% tax rate (long-term capital gains tax), you would be paying 30000 X 10% = Rs.3,000 as tax.
So, with the removal of indexation benefit, the debt mutual fund investors end up paying more tax and thereby gaining lesser return on their investment.
Further, there is of losing the principal amount while investing in debt mutual funds. Take the example of Silicon Valley Bank crisis, which occurred due to the loss of principal on government bonds held until maturity. The risk in debt mutual funds arises because of the nature of the bonds, which have varying maturities ranging from 10 to 30 years. In case an individual needs money before the maturity date, they may have to liquidate their investments in the secondary market, which can result in a loss of principal.
However, the recent amendment to the Finance Bill 2023 has leveled the playing field between fixed deposits and debt mutual funds. Fixed deposits are considered less risky than debt mutual funds, and the recent increase in taxes on debt mutual funds aims to level them to fixed deposits.
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It is important to understand the risks and rewards associated with different types of investments and making informed decisions based on individual financial goals and risk appetite.
Also read: 9 tips to select right mutual funds
