These days when interest rates have fallen off the cliff, Fixed Deposits have been losing sheen continuously. As result, people looking for alternatives to fixed deposits often compare Fixed Deposits with Debt Funds. And when such comparisons are made, many times we are told that it’s the tax efficiency of the debt funds that helps them score over fixed deposits.
Fixed deposits and debt funds are taxed very differently. So in this post, let’s focus on difference in taxation of FD Vs. Debt Funds.
Taxation of Fixed Deposit
Most of you would know this. The interest (or returns) from bank fixed deposits are taxable and are added to the depositor’s annual income and taxed according to the applicable tax slabs. The interest income from FD should be declared under ‘Income from other sources in your income tax filings.
Also, the banks will deduct TDS (tax at source) at the time they credit the interest to your account, and not when the FD matures. This is important to understand and it offers a ground to compare with the debt fund taxation.
So if you have an FD for 4 years and you have chosen the cumulative option to receive the interest at the end of the 4-year tenure, then you would still need to declare the FD interest income every year, as your bank will be deducting TDS (if applicable) and depositing it under your PAN. So you need to add the interest income to your total income in your IT Returns each financial year (even though, the interest may not be paid out as maturity is still some time away).
(To know more details, do read how fixed deposits are taxed in India 2023).
Now let’s see how this compares with debt funds.
Taxation of Debt Funds
The returns from debt funds are in form of Capital Gains. And depending on the investment horizon (or holding period) in debt funds, the capital gains are of 2 types:
- Short Term Capital Gains (STCG)– Gains made on investment in Debt Mutual Funds held for less than 3 years (or 36 months) are classified as Short Term Capital Gains.
- Long Term Capital Gains (LTCG) – Gains made on investment in Debt Mutual Funds held for more than 3 years (or 36 months) is classified as Long Term Capital Gains
As per the latest Debt Fund Taxation Rules (FY2023):
- Short Term Capital Gains (or STCG) on Debt funds are taxed as per the investor’s marginal income tax slab rate.
- Long Term Capital Gains (or LTCG) on Debt funds is taxed at 20% with indexation benefits.
So the short term gains are taxed in a manner similar to the taxation of fixed deposits. That is, as per the investor’s income tax slab rate. So if you redeem your debt fund investments before the completion of 3 years, it will get the same treatment as a fixed deposit and you will pay tax on your gains according to your income tax slab rates.
It is the taxation of long term capital gains (LTCG) that differs for debt funds.
Now, what is this indexation benefit that is available for taxation of LTCG from Debt Funds?
Let’s see this in detail.
Indexation Benefit is available for taxation of Long Term Capital Gains from debt funds.
Indexation is a way to adjust capital gains as per the prevailing inflation index. This helps lower overall liability to pay taxes by inflating the purchase cost, thereby reducing the effective capital gains.
Let’s take a small example to understand this concept.
Suppose you invested Rs 20 lakh in a good debt fund in August 2016. After a little more than 4 years, i.e. in October 2020, the value of your debt fund investments has become Rs 28 lakh.
Assume you plan to sell your debt fund investment at this point.
So mathematically speaking, you made capital gains of Rs 8 lakh, i.e. Rs 28 lakh – Rs 20 lakh. That’s your actual profit.
But this gain was made after a period of 4 years, which is more than 3 years requirement for capital gains qualifying as Long Term Capital Gains for Debt Funds.
So do you pay tax on this full Rs 8 lakh gain at the time of selling?
Because as per the latest taxation rules of mutual funds, the Long Term Capital Gains on Debt Mutual Funds are taxed at 20% after indexation. This means you need to adjust the cost of the acquisition of debt fund units for indexation first.
And for that, the following numbers are known:
- Cost of acquisition = Rs 20 lakh
- CII number for 2016-17, the year of purchase = 264
- CII number for 2020-21, the year of sale = 301
(Read how to use Cost Inflation Index (CII) number for LTCG Indexation Calculation)
So the indexed cost price of acquisition is calculated using the formula:
Indexed Cost = Actual Cost * (CII of Sale Year / CII of Purchase Year)
And in our example, this comes out as follows:
= Rs 20 lakh * (301/264) = Rs 22,80,303
And this means that the long term capital gains is calculated as follows:
= Rs 28,00,000 – Rs 22,80,303 = Rs 5,19,697 (~ Rs 5.2 lakh)
So you get taxed at 20% on this amount of Rs 5.2 lakh (instead of the actual profit of the full Rs 8 lakh without indexation). And this translates to:
LTCG tax of 20% on Rs 5.2 lakh, i.e. Rs 1.04 lakh (approx.)
Had it not been for indexation benefit, your tax would have been 20% on full actual profit of Rs 8 lakh: 20% of Rs 8 lakh = Rs 2 lakh.
To summarize, the purchase price of the debt fund (investment price) is multiplied by the CII for the year in which the sale is made and divided by the CII for the year in which the purchase was made. The indexed price so arrived at is used to calculate the capital gains on which LTCG tax of 20% plus surcharge and cess, etc. are applicable.
So indexation helps reduce your tax obligations considerably. And this is one of the biggest reasons that makes debt funds attractive.
And be reminded that the adjustment of the purchase price in Debt Funds (to accommodate indexation) is done just for calculating (and lower) the tax on capital gains and doesn’t actually reduce the actual gains or profit you made on your debt fund investments.
That is how the tax is calculated on debt mutual fund capital gains.
(To know more details, do read how debt funds are taxed in India 2023).
But debt funds are not risk-free. Even fixed deposits aren’t. But comparatively, risks in debt funds are slightly higher and you need to understand how to pick right debt funds.
Since the indexation benefit is available on debt mutual funds, it makes them more tax-efficient than regular bank Fixed Deposits. And this gives debt funds a big edge over bank deposits in terms of post-tax returns. Unlike debt funds where the capital gains are taxed only at the time of sale and that too with indexation benefits, the interest income on bank FDs is added to the total income every year and taxed as per the income tax slab applicable to the depositor.
Till now, debt funds have offered better returns than fixed deposits in recent years. And if that wasn’t a good enough reason, even from the tax point of view, the debt funds offer a better choice especially if you are in high tax brackets and can hold debt funds for the long term.
Fixed deposits and debt funds are taxed differently. Hopefully, after reading this post, you now know how Debt Fund Vs Fixed Deposit taxation differs (2023) in India.