Taxation : Fixed Deposit vs Debt Funds has been a topic of discussion since changes made in Finance Act 2023. Debt mutual funds invest predominantly in fixed-income securities like bonds, debentures, and other debt instruments. For taxation purposes, a specified mutual fund is defined as a mutual fund which invests less than 35% of its proceeds in the equity shares of domestic companies.
Taxation of Debt Mutual Funds before 1 April 2023:
Previously, the holding period rule governed the taxation of debt mutual funds::
- Short-Term Capital Gains: Debt mutual fund units sold within 36 months (three years) of purchase were termed short-term capital gains (STCG). These gains were taxed at slab rates.
- Long-Term Capital Gain: Units sold after 36 months (three years) of purchase were termed long-term capital gains (LTCG). Tax authorities taxed these gains at 20% with an indexation benefit. Indexation benefit meant that gains were adjusted for inflation before taxation.
Taxation of Debt Mutual Funds starting 1 April 2023:
The Finance Act 2023 eliminated the taxation based on a 3-year holding period for debt mutual funds. It now considers gains on debt funds as short-term capital gains, regardless of the holding period. The Act has phased out the indexation benefit for long-term debt mutual funds.
This implies that capital gains on debt mutual funds are now taxed at the investor’s applicable tax slab without indexation, similar to fixed deposits. These changes in debt fund taxation will have a negative impact on individuals falling under the 20%-30% tax bracket.
Taxation : Fixed Deposit vs Debt Funds:
From 1st April 2023, both profits from debt funds and Fixed Deposits are taxed at the income tax slab rate. However, unlike fixed deposits, debt funds are taxed only when the investments are sold. This feature can assist investors in deferring taxes.
Profits from debt funds are classified as capital gains, whereas profits from fixed deposits are categorized as ‘income from other sources.’ Consequently, in case of losses with debt mutual funds, these losses can be carried forward and offset against gains.