Certain revisions to Budget 2023 imply that a Specified Mutual Fund will no longer receive indexation benefits when computing long-term capital gains (LTCG). As a result, debt mutual funds are now taxed at the applicable slab rates.
Furthermore, indexation benefits for LTCG on gold mutual funds, hybrid mutual funds, foreign equity mutual funds, and funds of funds will be unavailable. As a result, mutual fund companies are anticipated to suffer as investors opt to invest directly in debt securities rather through debt mutual funds to minimise AUM fees/charges. The tax burden on profits may increase, which may reduce the appeal of these mutual funds as an investment alternative.
So, What Changed?
Let’s first discuss how debt money were taxed before to April 2023 in order to understand it. Depending on how long you invested for, there were two different tax brackets for debt mutual funds.
You were responsible for paying short-term capital gains tax if you sold your investments within three years. In essence, all of your profits were added to your income. In the highest tax bracket, the gains would be subject to a 30% tax.
However, if you sold your investment after three years, you would be subject to long-term capital gains tax. And as a result, debt mutual funds became a terrific choice for investors. After accounting for inflation, investors had to pay a 20% tax on gains (known as the indexation benefit).
Your tax amount decreases significantly when you adjust profits for inflation. It would typically be significantly lower than 10%.
This is better explained with an example. A bank fixed deposit yielding 8% results in a 5.6% after-tax return for people paying taxes at a 30% rate. What if, after three years, your debt mutual offered comparable returns? Before, there was a fair chance you’d earn more than 7.2% after taxes.
Where Should You Invest Now?
You previously classified your investment into short-term (less than three years) and long-term (more than three years) because debt mutual funds provided tax benefits.
Based on the possibilities accessible currently, you must decide if you require funds for the short term (less than two years), the medium term (2-4 years), or the long term (4+ years).
Less Than Two Years
Investors dislike short-term volatility, which occurs when your investments gain money one month and lose money the next.
You have three options for ensuring consistent returns. However, keep in mind that a lot is also dependent on the economy’s interest rate cycle. Right now, interest rates are extremely high.
| Debt Investment Options for Up to Two Years | ||
| Product | Feature | 2-Year Returns (%) |
| Fixed deposit | Stable and low risk | 6.8 – 7.55 |
| P2P lending | Riskier than FDs, higher returns | Up to 13 |
| Arbitrage funds | Replacement for money in the bank, tax-efficient | 4.96* |
*Past two-year category average returns. Data as of May 31, 2023.
Fixed deposit: Government institutions, such as the State Bank of India, give 6.8% to 7% interest rates on one- to two-year fixed deposits.
Higher interest rates on FDs are possible.
P2P lending: You can earn up to 13% on a two-year investment if you are willing to assume more risk than FDs. You can put money into Monexo Grow. You earn interest by lending money to creditworthy customers. Your investments are divided among 100-400 verified and creditworthy borrowers to reduce risk.
Yes, it is more risky than FDs. However, Monexo is governed by the RBI. However, don’t go overboard with any one debt product. P2P lending might account for 10% to 20% of your debt portfolio.
Arbitrage funds: Investors typically maintain some of their money in sweep-in fixed deposits and some in liquid funds. However, given the change in debt fund taxation, arbitrage funds are an alternative to explore.
These funds are currently more tax efficient than liquid funds. If you withdraw within one year of investing, you must pay 15% in short-term capital gains. After a year, the tax is 10% if your total stock gains in a fiscal year exceed Rs 1 lakh.
It is not a substitute for FD. Instead, they serve as a replacement for maintaining money in a bank account. In the past 5 years, these funds have averaged a 4.7% return.
2 to 4 years
Fixed deposits may be appealing in the medium term given the current interest rate environment. But there’s a catch. Reinvestment risk is inherent in FDs.
Nobody knows what interest rates three to four years from will be now. Premature withdrawal from FDs might also be costly because of the penalty.
When investing in the medium to long term, easy liquidity should be a criteria.
So, what are your alternatives?
Of course, debt funds.
If your investment horizon is up to 36 months (about 3 years), there is no change in the taxation of debt funds.
If interest rates change, they will be beneficial even over a four-year investment horizon. This is because, when interest rates fall, they can provide higher returns than fixed deposits.
More than 4 years
Long-term debt investments may have additional possibilities. However, before making a decision, you must be clear on the investing purpose and time horizon. Each investing channel has a purpose, but it all relies on your needs.
| Investment Options for Above 4 Years | ||
| Product | Feature | 2-Year Returns (%) |
| PPF | Guaranteed returns, govt-backed, tax benefits | 7.1 (Can change quarterly) |
| Traditional Insurance plans | Guaranteed returns, tax benefits | Varies with product |
| Debt funds | Flexibility, high liquidity | Varies with product |
| *For investment up to Rs 5 Lakh | ||
* Past two-year category average returns. Data as of May 31, 2023.
Public Provident Fund: Consider the PPF to be a 15-year fixed deposit that you cannot withdraw from. When you invest, you receive tax benefits, and there is no tax on withdrawal.
However, PPF rates might fluctuate every three months. It should not be a reason to be worried. PPF has historically provided interest rates that are either higher than or equal to those of long-term fixed deposits.
The only issue is that you can only deposit a maximum of Rs 1.5 lakh. Starting in the sixth year, you can make partial withdrawals. However, you must avoid it because it has an impact on your results.
Traditional insurance plans: Don’t be surprised if we bring it up. With the shift in debt mutual fund taxes, traditional insurance policies may be a viable long-term investment alternative.
There are three things you must ensure.
- One, look for an insurance that provides near to G-sec returns. Long-term G-sec rates are currently about 7%.
- Second, you’ll need to grasp XIRR (extended internal rate of return) returns.
- Three, at the end of the tenure, the returns should be tax-free. The insurance coverage must be at least ten times the annual cost, and the premium amount must be less than Rs 5 lakh every fiscal year.
Assume you obtain a policy that provides a tax-free XIRR of 6.5%. In the current situation, that appears to be a viable choice.
Mutual funds: They are an excellent tool for reducing risks and optimising returns by diversifying across different assets. And using a portfolio strategy to investing implies that you will rebalance your portfolio on a regular basis.
No other debt product provides the level of flexibility that mutual funds do. When rebalancing the portfolio, you can sell as few or as many units as you choose. This means that the remaining investment will grow. Saving taxes is not the primary objective when rebalancing your portfolio. The emphasis is on lowering risk in your portfolio.
While the shift in debt-fund taxes is unfortunate, there are a lot of options for meeting your fixed-income investment needs.
Choose your option!
