The month of March has a special place in investments. There is heightened investment activity due to the last minute rush to “save taxes”. Any product that offers tax benefits is in big demand and the investment flows peak across investment products. The big gainers of these flows are generally equity linked saving schemes, Life Insurance, Health Insurance and Public Provident Fund.
However, through this blog, I would like to focus on debt funds, and in particular, the tax efficiency they bring. Debt Funds are also referred to as Fixed Income Funds or Bond Funds. Since they do not invest in equities, they carry a much lower risk and are often compared to Fixed Deposits. However, they differ significantly from fixed deposits in the manner in which they are taxed.
Fixed Deposits vs Debt Funds Taxtion
When you invest in a Fixed Deposit, you earn a fixed rate of return and the income from a FD is added to your overall income and taxed at the marginal tax rate that is applicable to you. What this means is that if you fall in a 30% tax bracket, you will pay a tax of 30% on the interest earned on the Fixed Deposit.
The basis of taxation in the debt fund is the capital gains that arise from your investments (difference between your sale price and buy price). If the holding period of your investments is 3 years or lesser, then the capital gains get categorised as Short Term Capital Gains (STCG). In case the holding period of your investments is greater than 3 years, then the gains are categorised as Long Term Capital Gains (LTCG).
The taxation of STCG is very similar to Fixed Deposits. You add the STCG to your overall income and pay as per the tax rate that is applicable to you.
However, LTCG is taxed at a flat rate of 20% ( irrespective of the income tax slab that is applicable to you). Further, you can adjust your acquisition cost to reflect the impact of inflation. This is done by taking into consideration the Cost Inflation Index (CII). The value of the index is published by the government of India every year.
Why is investing in March more beneficial?
As I have shared earlier, as per current tax laws, LTCG is taxed at a flat rate of 20% after adjusting the cost of acquisition using the Cost Inflation Index.
However if you invest in March and hold the investments for 3 years and 1 month (till the financial year changes), you can avail of an additional year of indexation benefit. Below is an example that illustrates how availing 4 Indexation benefit can help you enhance your post tax returns.
As you can see from the example above, you can get a significantly higher post tax return by just investing in a debt fund over a FD, and can enhance that further by investing in the month of March and taking advantage of the tax laws. The difference in the pre-tax and post tax returns is even more stark if you factor in Surcharge and Cess or if you fall in an even higher tax bracket.
Conclusion
I am sure that you now appreciate the reason why March is so important a month from an investment perspective, specially if you are a fixed income investor and your investment horizon is 3 years plus.
As I write this article, Brent oil prices have hit a record high of USD 100 per barrel, inflation numbers are at record highs across most global markets and India too is bracing up to face the impact of higher inflation. Further, March is generally tight on liquidity and we have often noticed the impact of the same on interest rates. Both these factors can prove beneficial for long term investors in debt funds as interest rates are expected to inch up.
In conclusion, all I would say is, if you are considering three year plus investments in debt funds, it would be a great time to invest before March 31st!
Disclaimer: In the article, all examples are for illustrative purposes only. It should not be construed as an investment advice of any kind and/or recommendation to buy or sell the fund. Mutual funds are subject to market risks, please read all scheme related documents carefully.
