 "How to beat the debt fund tax")
A tax benefit of Rs 1,300-3,000 a month isn't huge, but the Budget proposals on individual taxation came as a huge relief as the benefit came after many years in the form of increase in the basic exemption limit to Rs 2.5 lakh (Rs 3 lakh for senior citizens); increase in the 80C and public provident fund limits to Rs 1.5 lakh and in the higher home loan interest benefit of Rs 2 lakh.
The middle class would also heave a huge sigh of relief after the Union revenue secretary's assurance on Saturday that there would be no retrospectivity in the flat 20 per cent tax on debt mutual funds.
But the doubling of the tax and the higher holding tenure for getting long-term capital gains benefits would still remain a sore point. Now, if the investor sells the units in less than 36 months, capital gains will be added to their income and taxed as in their tax bracket, much like bank fixed deposits (FDs). There isn't any clarity on the inflation indexation benefit that investors used to get in their investments in debt instruments.
But there are many others who suggest ways out of the tricky situation. Here's how.
Tenure critical for highest tax bracket
From the tax rate point of view, investors in the highest bracket will not lose if they stay invested for three years. For, at 20 per cent, debt funds are still better than the FD tax rate of 30 per cent. However, if they take out the money before three years, they will have to pay the tax at the same rate of 30 per cent. Earlier, they benefited from the 10 per cent without indexation and 20 per cent with indexation regime.
Rate of return key for middle tax bracket
For investors in the 20 per cent tax bracket, things will be trickier. Both FDs and debt funds will be taxed in the same way, both in the short and long term. Here, the rate of return will come into play. At present, State Bank of India offers nine per cent for FDs of one year and above, whereas debt MFs have returned eight to 11 per cent. Income funds and gilt funds have suffered in the past year, returning only two to six per cent, according to data from Value Research.
If retail investors in the medium tax bracket choose good schemes, they will earn higher returns. They could, in fact, look at hybrid debt funds, which invest a little over 65 per cent in debt and the rest in equities. While their tax treatment will be like debt funds, some of them are returning a good 15-20 per cent or even more. Says Hemant Rustagi, CEO, WiseInvest Advisors: "Investors who put money in hybrid funds will give themselves the opportunity to negative the tax impact partially due to higher returns."
Lowest tax bracket should go for fixed deposits
Investors in the lowest tax bracket (10 per cent) should not show any interest in debt funds, especially if the intent is to invest for more 3 years, as long-term capital gains will be taxed at 20 percent. If they invest for less than 36 months, short term capital gains will be taxed at 10 percent, which is the same as in the case of fixed deposits. However, by investing in high yielding debt hybrid funds, they can get higher returns than traditional options like bank deposits and bonds.
How to still enjoy debt funds
If you are in the highest tax bracket but your spouse or family member is, say, a senior citizen getting the benefit of the higher basic exemption of Rs 3 lakh, or Rs 5 lakh if he/she is over 80, and don't have any income, you could invest in their name to get tax benefits. The capital gains could even become tax-free if the amount is below their exemption limits.
Arbitrage funds might emerge winners
This is one category likely to benefit from the new tax treatment. These, by their nature, are debt funds but they get the tax treatment of equity funds because they invest in equities. Typically, if the stock price of Reliance Industries is Rs 967 on the BSE exchange and Rs 970 on the National Stock Exchange, the fund manager will buy the stock on BSE and sell on NSE. Similarly, if there is a price difference between the spot and futures market, again, the fund manager will take advantage of that. These funds do quite well in volatile market conditions.
Since the strategy implies buying and selling at the same time, these funds aren't risky but the returns are low at nine to 10 per cent - similar to returns from most debt schemes and bank deposits. The advantage is, there will be no tax if the investor exits after one year, as the long-term capital gains tax for equities is zero. On the other hand, if the investor exits before one year, there will be a short-term capital gains tax of 15 per cent.
DDT depressant
The Union Budget has also increased the dividend distribution tax by 2.47 per cent. For investors, such as retired persons and others, who want regular income, this is a hitch. If they can, they should go for a growth option which will help them earn tax-free returns.
The middle class would also heave a huge sigh of relief after the Union revenue secretary's assurance on Saturday that there would be no retrospectivity in the flat 20 per cent tax on debt mutual funds.
But the doubling of the tax and the higher holding tenure for getting long-term capital gains benefits would still remain a sore point. Now, if the investor sells the units in less than 36 months, capital gains will be added to their income and taxed as in their tax bracket, much like bank fixed deposits (FDs). There isn't any clarity on the inflation indexation benefit that investors used to get in their investments in debt instruments.
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Financial planners such as Gaurav Mashruwala are worried. Says he: "It would be unfair on debt investors if the indexation benefit is taken away."
But there are many others who suggest ways out of the tricky situation. Here's how.
Tenure critical for highest tax bracket
From the tax rate point of view, investors in the highest bracket will not lose if they stay invested for three years. For, at 20 per cent, debt funds are still better than the FD tax rate of 30 per cent. However, if they take out the money before three years, they will have to pay the tax at the same rate of 30 per cent. Earlier, they benefited from the 10 per cent without indexation and 20 per cent with indexation regime.
Rate of return key for middle tax bracket
For investors in the 20 per cent tax bracket, things will be trickier. Both FDs and debt funds will be taxed in the same way, both in the short and long term. Here, the rate of return will come into play. At present, State Bank of India offers nine per cent for FDs of one year and above, whereas debt MFs have returned eight to 11 per cent. Income funds and gilt funds have suffered in the past year, returning only two to six per cent, according to data from Value Research.
If retail investors in the medium tax bracket choose good schemes, they will earn higher returns. They could, in fact, look at hybrid debt funds, which invest a little over 65 per cent in debt and the rest in equities. While their tax treatment will be like debt funds, some of them are returning a good 15-20 per cent or even more. Says Hemant Rustagi, CEO, WiseInvest Advisors: "Investors who put money in hybrid funds will give themselves the opportunity to negative the tax impact partially due to higher returns."
Lowest tax bracket should go for fixed deposits
Investors in the lowest tax bracket (10 per cent) should not show any interest in debt funds, especially if the intent is to invest for more 3 years, as long-term capital gains will be taxed at 20 percent. If they invest for less than 36 months, short term capital gains will be taxed at 10 percent, which is the same as in the case of fixed deposits. However, by investing in high yielding debt hybrid funds, they can get higher returns than traditional options like bank deposits and bonds.
How to still enjoy debt funds
If you are in the highest tax bracket but your spouse or family member is, say, a senior citizen getting the benefit of the higher basic exemption of Rs 3 lakh, or Rs 5 lakh if he/she is over 80, and don't have any income, you could invest in their name to get tax benefits. The capital gains could even become tax-free if the amount is below their exemption limits.
Arbitrage funds might emerge winners
This is one category likely to benefit from the new tax treatment. These, by their nature, are debt funds but they get the tax treatment of equity funds because they invest in equities. Typically, if the stock price of Reliance Industries is Rs 967 on the BSE exchange and Rs 970 on the National Stock Exchange, the fund manager will buy the stock on BSE and sell on NSE. Similarly, if there is a price difference between the spot and futures market, again, the fund manager will take advantage of that. These funds do quite well in volatile market conditions.
Since the strategy implies buying and selling at the same time, these funds aren't risky but the returns are low at nine to 10 per cent - similar to returns from most debt schemes and bank deposits. The advantage is, there will be no tax if the investor exits after one year, as the long-term capital gains tax for equities is zero. On the other hand, if the investor exits before one year, there will be a short-term capital gains tax of 15 per cent.
DDT depressant
The Union Budget has also increased the dividend distribution tax by 2.47 per cent. For investors, such as retired persons and others, who want regular income, this is a hitch. If they can, they should go for a growth option which will help them earn tax-free returns.