In the last week of March, the government made a unilateral announcement regarding the change in taxation regime for debt mutual funds. This announcement came as a surprise to the investor community as it happened almost without any prior warning and without any feedback or discussion (PS it wasn’t even a part of the union budget speech!) 

Under the newly announced Tax Regime, the government has removed the indexation benefit available to debt mutual fund investment. Let’s understand what this change exactly is and how it will affect you as an investor:

The Change:

Based on the amended finance bill passed on 24^th March 2023, gains from new investments made after 31^st March 2023 in debt mutual funds will be taxed as per individual slab rates irrespective of holding period and no indexation benefit will be available. Prior to this gains from debt mutual funds where holding period was less than 3 years were taxed as per slab rates and those with holding period more than 3 years were taxed at 20% along with indexation benefit.  The change basically applies to all categories of debt funds like Egg. pure Debt Funds, Conservative Hybrid Funds, Fund of Funds, Multi Asset Funds as well as International Equity FOFs. The domestic equity component in these funds is less than 35%.

Why was it made?

By bringing in this change the government aims to provide a level playing field to bank FDs and Debt Mutual Funds. Prior to this debt mutual funds were always the first choice for say a large investor, as it provided better tax adjusted returns. Bank FDs were traditionally taxed at slab rates without indexation. Hence, if your taxable income is in the highest tax bracket i.e 30%, you will end up paying 30% as tax on Bank FD interest. However, if instead of bank deposits you chose to hold your investment in debt mutual fund for more than 3 years, your capital gains would be taxed at 20 % along with indexation benefit.(indexation benefit basically allows you to deduct a inflation adjusted cost from your sales proceeds to arrive at a capital gain)

How does it affect you?

For all your existing investments made in debt mutual funds the tax regime will remain the same (if holding period > 36 months, you will be taxed at 20% along with indexation benefit). This change affects your investments made post 1^st April 2023. Moreover, it will hits investors in the highest tax bracket the most. For an investor who is in the 30% tax bracket will be adversely affected by this change. Not only will the investor loose the indexation benefit but he will also be taxed at higher rate. Let’s understand this with a simple example “

What can you do as an individual investors?

All in all, the last two months have been truly taxing for individual investors. These changes definitely make debt mutual fund investments lack lustre as compared to earlier. The change basically brings taxation on bank FDs and debt mutual funds on par with each other. Though with was made with an aim to tighten the noose on HNIs using debt mutual funds as an arbitrage to reduce tax on their investments, it will affect you as an ordinary investor.  As an individual investor this is what you can do now :

1. Use Aggressive Hybrid Funds or Balanced Advantage Funds in which the equity investment is between 35 % – 65 %. These will get taxed as per the earlier tax regime, i.e for holding period more than 3 years, they will be taxed at 20% with indexation benefits. Additionally the equity portion can help you earn attractive inflation adjusted returns.

2. Use guaranteed income schemes from insurance providers which have the potential to provide tax adjusted returns to the tune of  7+ % along with long term lock-in of 20 years +