How to Save Tax on Debt Mutual Funds under the New Regime? Know Everything

If you are looking to read the way how to save tax on debt mutual funds under the new regime then this available information can help you. Here we will read briefly about how you can save tax under the new regime. But before this, we have to read some basics here and know what is debt mutual funds. Read More Business News on our website.

How to Save Tax on Debt Mutual Funds?

These are investment vehicles that invest primarily in fixed-income securities such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. The returns on these investments often come in the form of interest payments or capital gains, making them an attractive investment option for conservative investors.

Current Taxation of FCPs Until recent amendments, the taxation of FCPs was governed by indexing rules and holding periods.

(A) Short-term debt mutual funds:

If mutual fund units are redeemed no later than 36 months (three years), the gain on the units is called short-term capital gain. These capital gains are taxed at the rate of your income. (B)

Long-term Debt Mutual Fund:

However, if the holding period exceeds 36 months, the gain is known as long-term capital gain (LTCG). These long-term capital gains are taxed at 20% with indexing gains.

In other words, this means that the returns investors make are adjusted for inflation, thereby reducing the tax payable on the investment. 

Typically, investors tend to view their capital gains as just a profit/loss account, which may not be the ideal solution.

Let’s look at the stats

Let’s say you have invested ₹100,000 in a mutual fund with a term of 4 years. You invested this amount in June 2022. June 2022 falls in the fiscal year 2022-23. Now, after four years you buy back your mutual fund investment and get ₹120,000. You will buy back your investment in May 2026, which falls in the 2026-27 fiscal year. Thus, your return on investment or capital gains is ₹20,000 or 20% of your primary investment.

The New Change in the Mutual Funds Tax Regime

Proposed Change to Designated Mutual Funds (SMF) and its Impact In line with changes made in Budget 2023 – the indexing to calculate long-term capital gains for A designated non-profitable mutual fund (i.e. a mutual fund scheme not exceeding 35%) will be available for investments made on or after April 1, 2023. In short, it will be discontinued and will be taxed at the rate applicable to your income bracket. 

Steps to save Tax on Debt Mutual Funds?

Indexing can be of great help in terms of savings for debt funds.

In simple terms, indexing is adjusting returns by taking inflation into account. It indirectly calculates the loss on return of your mutual fund investments due to inflation. After indexing calculations, interest is adjusted for inflation and is usually lower than your actual return.

When you calculate taxes on these inflation-adjusted returns, your tax liability is reduced. As a result, you pay a lower tax on indexed profits. You can get the benefits of indexing debt mutual funds by investing in debt funds for three years or more.

To check the benefits of indexing your investment, you can check the indexing rate. Over the life of your investment, you can calculate the indexing rate using CII (Cost Inflation Index) metrics. CII is published by the government every year. 

The government publishes CII figures each year, representing the inflation rate for that year. As the inflation rate keeps changing every year, the ITC rate also changes every year. The ITC rate corresponds to 75% of the average annual increase in retail price inflation.

Let’s Verify by Stats Again: After Considering Indexation

Here is the formula to calculate the index:

Indexation = Actual price paid for investment x (ICI for five funds sold/ICI for five funds invested). 

ITC for 2022 is 331. Now suppose ITC for 2026 increases to 340

Indexing = 1,00.000 x (340/331) = 1,00.000 x 1.03 = ₹1.02.719

Now your capital gain after taking into account indexing will be = ₹1,20,000 – ₹1,02,719 = ₹17,281

As a result, your final capital gains taxed under LTCG will be reduced from ₹20,000 to ₹17,281 due to indexing.

The benefit of indexing will only apply if inflation is positive. If the inflation rate becomes negative, you may not be eligible for indexing support. Indeed, indexing does not apply in a deflationary situation.

So will you pay more taxes than capital gains if inflation falls below 2022 levels in 2026?

ARE NOT. This is because CII is calculated as 75% of the change in CPI inflation over the previous year. Therefore, even if CPI inflation declines significantly, its difference from the previous year’s CPI could be larger. As a result, you won’t have to pay LTCG on a lower-than-true capital gain figure, even if inflation declines in 2026.

In addition, you must continue to invest for at least three years in a mutual fund to receive the benefits of indexing.

Once you’ve calculated the indexing rate for your investment, here’s how you can recalculate your mutual fund return. 

We all want to preserve our return on investment from inflation. This reduces the value of our profits and takes us away from our financial goals. Mutual fund indexing is like a tax break that can offset the loss in value of our investment due to inflation. The benefits of mutual fund indexing can be to reduce the ultimate tax burden on your capital gains. So when the value of your capital gains decreases due to inflation, you will be covered by paying less inflation-adjusted capital gains tax. Also, read more latest business news on our website.