Your guide to debt funds: How you can gain from less-known fund category

Tax Treatment

1)       While the interest earned on deposits and bonds is added to your income and taxed at the applicable rate, the income from debt funds held for more than one year is treated as long-term capital gain and taxed at a lower rate. This is a bonanza for anybody with a taxable annual income of over Rs 10 lakh. Instead of paying 30% tax on interest from fixed deposits, he can pay only 10% tax on long-term capital gains from debt funds. The tax could be even lower if he opts for the indexation benefit, which adjusts for inflation during the holding period

 

2)       A major draw is that you can indefinitely postpone your tax liability by investing in debt funds. The interest income is taxable on an annual basis, irrespective of the time that you actually get it. You need to pay tax on the interest accruing on a cumulative fixed deposit or a recurring deposit even though the instrument has to mature in 5-10 years. On the other hand, your investments in debt funds will not have a tax implication till you withdraw them. This also makes these funds the best way to invest in your child's name. When you put the money in your minor child's name, the income from the investment is treated as that of the parent who earns more. This clubbing of income is meant to prevent tax leakage, but investments in mutual funds can circumvent this provision. If the funds are redeemed after the child turns 18, the capital gains will be treated as his income, not yours

3)       There are other ways to earn tax-free income from debt funds. You can set off losses from other assets against the gains from these schemes. Tax rules allow carrying forward of capital losses for up to eight financial years. For instance, if you had booked short-term losses on stocks and equity funds when the markets slumped in December 2011, you can adjust them against the gains from your debt fund investments till 2019-20

4)       Any short-term capital gain is taxed as income, but you can get past this with the dividend advantage. Though they are tax-free, dividends of debt schemes reach the investor after the deduction of dividend distribution tax. This is 13.8% for debt funds and 27.4% for liquid funds. Even so, this is lower than the 30% tax an investor in the highest income bracket will pay on withdrawals before one year of investment.

Liquidity

Liquid funds live up to their name. If you redeem before 3 pm, the money is in your account by 12 noon of the next working day. In other debt funds, it is with you by the second working day

 

 

Five common circumstances where debt fund schemes can prove beneficial

Five common circumstances where debt fund schemes can prove beneficial

1) Saving for a short-term goal

If you need the money in 6-12 months, go for ultra short-term or short-term debt funds. The returns of these funds are not volatile because they invest in bonds of very short maturities. Any change in interest rate does not affect them. You can expect a return that is comparable with those from fixed deposits of the same tenure. While there is no difference in the applicable tax rate if you are withdrawing your investment within a year of investing, you do get the liquidity advantage, as also the flexibility of a mutual fund. You can also opt for a liquid fund for this purpose, but a short-term debt fund may be able to give you slightly better returns. Of course, the difference of 10-20 basis points in the returns should not matter if you invest for six to eight months. Do consider the exit load of the fund when you invest.

2) Need money at a very short notice

The tenure of the investment is not always fixed. Noida-based Feroz Mehmood (see picture) may need the money at a short notice if he comes across a good deal in real estate. A liquid plan is best suited for goals with undefined tenures. These plans do not levy any exit load and the growth is slow and steady. The most important aspect of these schemes is the safety of capital. Since the funds are invested in the call money market, there is virtually no chance of a default or credit risk. There's also the liquidity they offer. If you redeem the investment before 3 pm, the money is credited to your account by 12 noon of the next working day. The returns are only a tertiary concern. In recent months, liquid plans have given decent returns comparable with FDs.

 

3) Avoiding high tax on fixed deposits

The tax advantages of investing in a debt fund have already been spelt out in detail. However, income funds can give you more than just a low tax rate. In a scenario where interest rates are expected to go down, these medium-term debt funds stand to gain. In the past 6-12 months, these funds have given returns that are at least 100-200 basis points higher than the prevailing fixed deposit rate. This is because of the inverse relationship between interest rates and bond fund NAVs. By that logic, long-term funds may appear attractive, but they are also very volatile.

 

4) Large sum to invest in equity funds

The benefits of debt funds extend to equity investments too. Financial planners say that if you have a large sum to invest, you should not do it at one go, but in monthly SIPs. However, if you put the money in a savings bank account, it will earn a piffling 4-6% interest. Instead, put it in a debt fund and then create a systematic transfer plan (STP) into an equity fund. This is similar to an SIP, except that the money comes from the debt fund, not your bank account. This is possible only in schemes from the same fund house. This means you must first identify the equity fund you wish to invest in and then put the money in a debt fund from the same fund house (see table). Some fund houses even waive exit loads on STPs