Why Should One Invest in Debt Mutual Funds?

In Mutual Funds by Gunjan Massey1 Comment

The Union Budget for the year 2014 brought major changes in mutual fund non-equity schemes. Before the budget, when you purchased debt funds instead of bank FDs, you could benefit from big tax arbitrage. By holding onto the units for one year, you could enjoy Long-Term Capital Gains. Taxation on such gains was quite low at only 10% of the absolute gain and 20% indexed gain. This was because the index gain was adjusted as per inflation, with taxation only on the capital beyond the inflation impact. In the post-Union Budget scenario, things have changed because this tax arbitrage is no longer there. Now, you must hold the debt fund not for one year, but for three years to claim the capital long-term tax benefits. Otherwise, you will get only the short-term gains minus the lower tax rate and no indexation.

So, why should you still invest in Debt Mutual Funds? Here are the reasons:

Fixed Income

You can still diversify your portfolio by investing money in debt mutual funds. The allocated portion in debt funds protects your capital from market fluctuations. So, you stay away from the volatile equity scenario, while generating a regular income.

Lesser Risk

Risk factors associated with debt mutual funds are quite low when compared to equity vehicles. Due to lesser exposure, your fund remains safe and accrues over the years. However, you cannot do anything about the exposure of your debt funds to credit risks and risks related to the interest rates.

Higher Returns than FDs

Even though the union budget has taken steps to bring debt funds and fixed deposits almost at par, debt funds may still be a better option for investors. Given the high inflation rate, when you use indexation method to redeem debt units after the three-year lock-in period, post-tax returns might still be higher than bank FDs.


Redemption of debt funds does not involve any tax deducted at source (TDS) which is applicable in the case of a bank fixed deposit, when yearly interest earning is over INR 10,000.

No TDS, If You Don’t Exit

Tax on debt MF investments doesn’t accrue in cases where the investor takes the no exit stance. This however does not happen in a fixed deposit. In case of FDs, the investor needs to pay yearly taxes on accrual except in cases where the cash system of accounting is present. If you are holding a long-term account for 3+ years, taxesapplicable become quite low due to the indexation benefits and it is almost nil for now. This is because currently the inflation rate is almost at par with the income earned through that mutual fund investment.

Benefit from Tax Arbitrage

Debt fund, dividend option retains the tax arbitrage and it attracts Dividend Distribution Tax (DDT) 28.3% rate,
which is 2.57% lower than tax on interest earned from bank FDs. Naturally, this makes the debt mutual funds quite attractive. So, if you have written yourself off from mutual fund investments post 2014 budget, don’t be hasty because its benefits may still override the limitations.

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