Tread with care on debt mutual funds

Mutual fund investors pretty much got a raw deal from Finance Minister Arun Jaitley. The Budget has made your FMP (Fixed Maturity Plan) and debt fund investments less attractive, thanks to higher taxes imposed on them. Though the benefit of indexation could reduce the impact on other debt funds quite significantly, FMPs − especially those with a 1-3 year tenor − will bear the brunt of this move. These FMPs will now lose out to bank fixed deposits.

The Budget clearly states that all non-equity mutual funds will suffer higher taxes. So international funds and gold schemes are also likely to be saddled with higher tax. The increase in dividend distribution tax also comes as a blow to investors.

But on a positive note, retirement mutual funds will now be afforded a tax treatment similar to regular pension funds, such as the NPS. Earlier, if you sold your investment in a debt fund after holding it for one year, the gains you made were considered ‘long-term’ and taxed at 10 per cent. The Budget has made two changes in this regard. Firstly, the timeframe has been increased from one to three years (12 to 36 months) and secondly, the tax has been hiked to 20 per cent.

So if you now make a long-term capital gain of 30 per cent after three years, your effective gain post-taxes would be 24 per cent, compared to the 27 per cent return you would have enjoyed earlier.

Thankfully, the indexation benefit continues to exist; your gains would have been much lower if indexation was factored in. As a consequence, the taxes payable on the gains would be proportionately lower.

FMPs stand to lose out significantly from this move. There were popular plans with a 13-month tenor that allowed the purchase of units in March of the first year and redemption in April of the next year. This allowed investors to gain from double indexation for two financial years, thereby paying little or no tax. Under the new rules for FMPs with a 1-3 year tenor, the gains would be added to your income and taxed at your slab rate.

So now, for those in the 10 per cent tax slab rate, fixed deposits at a comparable interest rate would be more attractive, as you would only pay 10 per cent tax, compared to the 20 per cent you would have to pay in the case of FMPs. Moreover, for a holding period of less than three years, you will have no indexation benefit for FMPs.

Choosing the dividend option in debt funds such as MIPs would now result in a lower payout, as dividend distribution tax would be at a higher rate.

The effective rate is set to go up from 28.33 per cent to 33.99 per cent.

Since the Budget proposal includes all non-equity funds, schemes that invest in overseas stocks to the tune of more than 65 per cent of their portfolio, too, would attract higher taxes as they are treated as debt products for all practical purposes. Gold funds, too, would be affected by the new provisions. In general, it is advised to limit exposure to international schemes and gold funds to 5-10 per cent of your portfolio. The added tax disincentive means that you must strictly adhere to these limits.

Offering some solace is the proposal for uniform tax treatment of pension funds and mutual fund-linked retirement plans.

Affording the same tax treatment as pension plans such as the NPS means these retirement funds will fall in the EET category (exempt-exempt-taxed).

What’s more, once the DTC comes to force, NPS is set to become an EEE (exempt-exempt-exempt) scheme, giving you a tax benefit on your initial investment, on accumulation and on receipt of the maturity amount. As such, so would mutual fund-linked retirement plans. It remains to be seen if fund houses use this opportunity to launch dedicated retirement plans.