tax implications for debt fund investors

Differential tax treatments inevitably hurt investors who do not understand them. One area this happens is in the investments made in the debt, or income, schemes of mutual funds. Months ago I wrote an advisory story/article on this issue it in the newspaper I presently work for.

Here is what I wrote:

Extract optimum returns from your debt fund

Tax implications affect net return of debt fund investors. So choose carefully between growth and dividend options.

Having a little or lot of your investments in low-risk fixed income instruments appears to most to be an easy task but it takes a lot of understanding of the complexities of returns in terms of tax liability, timing, interest rate fluctuations and other factors to be able to pull it off in the most prudent way.  Till a few years ago the simplest way to have a low-risk fixed income investment exposure was to put money into bank deposits available in multiple tenures from a few months to a few years.

But in recent years as increasing number of retail investors have got conscious of the option of debt funds offered by the domestic mutual funds such as open-ended funds--liquid, short term income, income and monthly income plans--and close-ended debt funds--fixed maturity plans and interval the need to understand the complexities has become quite essential.

After making the choice of debt funds an investor would face the next daunting task of choosing between  the three options of growth, dividend payout and dividend reinvestment every debt fund offers. A debt fund has a common portfolio for investors in it irrespective of the option they choose. So the gross return on all the three options largely stays the same. But the net return after factoring in tax implications and opportunity cost varies.

You do not pay an tax on the dividends declared by debt funds whether and paid out to you or re-invested in the form of fresh purchases. But since the fund has to pay a dividend distribution tax (DDT)—27.04 per cent if it is a liquid fund and 13.52 per cent if it is a non-liquid debt fund, the fund’s net asset value is less by the DDT.

Growth option, where no dividends are declared and the NAV rises by the accumulated earnings of the debt fund,  works the best if your intended investment period is more than one year as you will then bear only a long-term capital gains tax of 10 per cent without indexation or 20 per cent with indexation which will be lower than the DDT of 13.52 per cent.

Dividend payout in debt funds works best if you intend redeeming your investment in less than a year if dividends are regularly declared and you don’t incur any short-term capital gains. The DDT of 13.52 per cent in non-liquid debt funds works out to be lower than your tax liability if you are in the 20 per cent or 30 per cent tax slab as short-term capital gains are added to your total income.

Dividend re-investments serve no useful purpose for debt fund investors as it requires you to continuously juggle with the time horizon of your initial and subsequent dividend re-investments. Watch out, though, as most debt funds compulsorily re-invest your dividends even if you have selected the dividend payout if the dividend amount is small. Also, many internet-based MF distributors do not keep the dividend pay-out enabled for a vast majority of debt funds.