There are plenty of things that you should keep in mind before you invest in mutual funds. This ranges from the profitability of the fund to the expenses that come with investing in them. But one factor that most people forget is the tax liability of the fund you invest in. This is especially true in the case of debt funds.

But how are debt funds taxed? How do debt fund tax rates fare with that equity funds? Let us find out through this article.

What are debt funds?

To understand debt funds‘ tax ability, you must first understand what debt funds are. Debt funds are mutual funds that invest primarily in debt instruments. This includes bonds, government securities, treasury bills, etc. These instruments are a way to get regular income from your investments. For example, let us take the case of bonds.

Bonds are a way for corporates and governments to raise money. The investment you make is the money the issuer raise. For that investment, you are entitled to get an interest payment. This lasts till the end of the maturity period, and at maturity, you will get your money back. Most debt instruments work similarly.

Taxation of debt funds

Returns from debt funds are categorized into two in terms of taxation – short-term capital gains and long-term capital gains. Both taxation methods have different tax rates and different methods of collection. Let us take a look at them in detail.

Short-term capital gains

Short-term capital gains are your gains from a debt fund when you divest before 36 months of investments. To incentivize people to invest for longer, short-term capital gains are taxed at a premium compared to long-term funds.

In the case of debt funds, short-term gains are treated similarly to dividends. The gains are added to your current income tax slab and taxed accordingly.

For instance, if the returns from your debt fund in the short term are Rs.1 lakh and your annual income is Rs.10 lakh, the former will be added to the latter, and your total taxable income before deductions will become Rs.11 lakh.

The returns are taxed when you divest from the same to make taxation easier. For instance, if you divest before 36 months, the returns will be considered short-term and taxed according to your current income bracket.

Long-term capital gains

Long-term capital gains tax is applicable in the case of debt funds if your investment tenure is more than 36 months. But the way long-term gains are taxed is different as well. Your investments are also taxed when you divest, and if they fall under the long-term capital gains category, they will be taxed a flat 20%.

Taxability – debt vs. equity funds

Mutual funds are categorized into two for ease of taxation. Equity mutual funds are the ones with more equity presence, and debt mutual funds are the ones with more debt presence. We have already discussed how debt funds are taxed. Let us now take a look at how equities are taxed for better comparison.

Short-term capital gains for equities are taxed at a flat 15%. Your investment is considered short-term if your tenure is less than a year.

At the same time, long-term capital gains are taxed at a flat 10%. But LTCG up to Rs.1 lakh is exempted from tax in the case of equities. This makes equities slightly tax efficient, but they do come with a higher risk.

Conclusion

Understanding an investment option’s tax implications is important before you start investing. Hence, be sure to include the above information in your debt fund investment planning.