Union Budget 2023 was the great leveller where it concerned debt mutual funds. The budget removed the benefit of long-term capital gains (LTCG) tax rate of 20% and indexation for these funds. All capital gains from debt funds are now added to the investors’ incomes and taxed at their slab rate. The move took away the tax advantage that debt funds enjoyed hitherto over bank fixed deposits, wherein interest gains were always added to the investor’s income.
Now, investors in the highest tax slab are taxed up to 30% on capital gains arising from redemption of the debt funds, without any benefit of indexation. Typically, indexation helps reduce tax outgo as it lets the investor raise the acquisition price to account for inflation.
However, investors can still take advantage of the old tax rule if they can manage their investments in such a way that debt funds started in the previous years remain untouched. The new tax rule is applicable to investments in debt funds made after 31 March. All investments prior to this date continue to be grandfathered, i.e. these enjoy LTCG tax rate of 20% with indexation.
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Here is how investors can let their old investments compound into a sizeable and tax-efficient corpus over time.
Rebalancing act
Putting fresh money in new debt funds or mutual fund folios rather than in old fund is one of the ways in which investors can still keep a large part of their investments tax-efficient. “Investments needed for short-term objectives can go into new funds, so that older funds continue to build up their tax-efficiency with indexation,” says Amol Joshi, founder of Plan Rupee Investment Service.
Investment advisors often ask investors to adjust their asset allocations in line with market conditions. This practice is known as asset rebalancing. For example, an investor sticking to 60:40 equity-debt portfolio would be advised to buy more equity if the equity component slips to 50%, or vice-versa. Such asset shifts are also tax events, and investors would be forced to sell their old investments if a new fund or folio has not been created.
“This is the reason we are asking investors to put fresh debt fund money in new funds or folios. So, any re-balancing is taken care of by fresh investments. The investors can allow the older investments to accumulate in a larger and more tax-efficient corpus,” says Sumit Duseja, co-founder and chief executive officer of Truemind Capital, which is a Sebi-registered investment advisor.
Some advisors ask investors to rebalance their financial assets more dynamically, wherein they track market valuations and ask investors to switch from debt to equity more aggressively when equity valuations see sharp corrections. This strategy of creating new funds or mutual fund folios can be deployed by investors in their early investment accumulation phase when there are more instances of portfolio rebalancing or even in the middle phase of their financial plan.
More years, more indexation
Indexation is increasing the purchase price of the investments to reflect the impact of inflation. This indexation benefit is only applicable on investments made prior to 1 April.
So, if investors allow the grandfathered investments to compound over longer years, they would get the benefit of more indexation years. The LTCG tax rate is applicable after a three-year holding period for the grandfathered investments, but delaying the taxation event can help you compound your investments and reduce the tax outgo when you finally redeem your investments.
For example, an amount of ₹1 lakh invested on 30 June 2020 in a debt fund would grow to ₹1.49 lakh by 30 June 2027, assuming growth of 6% per annum. As this is grandfathered investment, it would eligible for indexation. So, the cost of acquisition would be calculated at ₹1.38 lakh for taxation purposes, which would imply capital gains of ₹10,129. This would translate into long-term capital gains rate of 20%, and tax outgo of ₹2,025. So, the effective tax rate would just be 4.1%.
Section 54F
Investments in old debt funds made before 1 April are still eligible for exemption under Section 54F of the Income Tax Act (IT Act), whereby a long-term capital asset other than a house property can be exempted from tax. However, to qualify for a long-term asset, the investment needs to be held for more than three years.
This exemption is available if proceeds from the sale of the grandfathered debt fund are re-invested in the purchase of a residential house two years from the date of such a sale. Or if the proceeds are re-invested in purchase of property within one year before such a sale. Such proceeds can be re-invested in properties under construction within three years from the date of such a sale.
Other funds
Apart from debt funds, the grandfathering clause is also available for gold funds and international funds. Investors can avoid touching old funds in these categories too for any withdrawals or asset rebalancing needs. Fund houses have also been launching multi asset funds, which can still take advantage of the LTCG rate and indexation benefit, while still having the flexibility of heavy debt allocation.
The Budget document removed the LTCG and indexation benefit for mutual funds with up to 35% equity exposure to domestic companies, which means funds having exposure of 35-65% to equity can still take advantage of old tax rules. These funds have the provision to take much higher exposure to debt, while still retaining the old tax advantage.
However, these funds cannot be considered as replacement for pure debt funds, which have 100% of their exposure to debt securities.