You’ve probably read about the change to taxation of debt funds that Finance Minister Nirmala Sitharaman announced as part of the Finance Bill 2023. The Bill basically ends all indexation benefits on the long-term capital gains on certain debt mutual funds, effective April 1, 2023.

The heat of this move will probably be felt by retail investors, high net worth individuals, and ultra-high net worth individuals who were used to parking their money in such funds.

Let’s take a quick look at what this change is, what it means for a balanced portfolio that contains debt funds in the mix, and what a future strategy could be in light of the tax rule change.

Firstly, what is the change announced?

As per the amendments announced, any debt mutual funds whose equity investments proportion is upto 35% of the overall portfolio will no longer be eligible for the indexation benefit while calculating long-term capital gains tax. This is applicable only for investments made on or after April 1st, 2023.

Only those debt funds where the proportion of domestic equity investments is >35% but <65% (which is the threshold for equity LTCG) will continue to offer indexation benefits if held for >36 months

See this tweet below from Sunil Jhaveri, well recognized Investment Advisor, Author & Coach.

In fact, read the entire thread here, it’s the best explanation + impact breakdown we’ve seen for this event.

What is the tax on long-term capital gains (LTCG) in debt funds?

Long-term capital gains tax is applicable on any profit you would have made by redeeming debt mutual fund units held for over 36 months (3 years). Earlier, the LTCG tax on debt funds was 20% but you would get the indexation benefit. This means, you could adjust your buying price to account for rising inflation, thereby reducing your profit on paper (only for taxation purpose) and therefore exposing a lesser quantum of your returns to the 20% tax.

But you will no longer be able to enjoy the indexation benefits on debt funds with upto 35% domestic equity investments, if purchased on or after April 1, 2023.

What could this mean?

Taxation norms will become similar for debt mutual funds as bank fixed deposits. This means that you pay taxes on both debt mutual funds and bank deposit returns based on your income tax slab.

At the same time, retail investors who wish to save every rupee in taxes might look at five-year bank deposits, given that at least the interest rate they are signing up for is predetermined and, well, fixed.

But here’s the catch- if you consider a fixed deposit with a 5-year lock-in period, your money gets tied up for a considerable time. Withdrawing it for any contingency before the lock-in period ends results in a penalty. Ultimately, you might end up not just paying the tax on the gains, but also a penalty- reducing your benefit considerably.

Now look at debt funds- although abolishing indexation benefits means a direct impact on certain debt fund returns, there remains a possibility of them outperforming the interest rate offered by fixed deposits. Compared to this, debt mutual funds may be able to help you achieve a higher bottom line. But yes, you will still take on a few risks involved with any market-linked debt investment as earlier.

Few things you may want to consider, oh debt investor:

1. Think beyond just taxation when making investments (unless your goal is to save tax, in which case: ELSS)
2. Don’t let fear, greed, or herd mentality guide your investment decisions
3. When the market is jittery, or when there are news-led movements, the best thing to do is actually to do nothing at all. No matter how much the noise around you.
4. Never lose sight of your objectives - your rationale for having invested in a debt fund, your motivation to have stayed invested, and your financial goals. Zoom out and relook at the big picture.

Now if you’re a well-heeled HNI looking at debt investments, we would suggest going for a corporate bond fund such as this one. These are debt funds that invest primarily in debt instruments of companies with the highest possible credit rating (SOV/ AAA etc)- given only to companies that are financially strong and have a high probability of paying lenders on time.

Of course, before making an investment decision, please do consult a qualified professional to assess your risk profile and suitability of the products to your portfolio before making investing decisions.