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