Do Debt Mutual Funds Offer Better Tax Benefits Than Bank FDs?

Investors seeking tax efficiency should prefer debt mutual funds over traditional bank fixed deposits (FDs). Starting from FY 2023-24, capital gains from the sale or transfer of debt mutual funds with equity investments below 35 per cent of their assets under management (AUM) will be treated as short-term capital gains (STCG). These gains will be subject to income tax rates based on the taxpayer’s income, regardless of the holding period. These funds had long-term capital gains (LTCG) indexation benefit which will only continue for investments made on or before March 31, 2023.

However, even for investors who want to invest now, debt funds still provide greater tax advantages than bank fixed deposits.

Benefit Of Deferred Tax

Debt mutual funds will still have an edge over bank FDs when it comes to other aspects, such as the benefit of deferred tax, as interest on fixed deposits is taxed on an accrual basis.  

This means that interest earned on bank fixed deposits is typically taxed annually, with banks deducting tax at source (TDS) subject to relevant TDS exemptions.  

For instance, in cumulative bank FDs, the depositor will only get interest income at maturity, but TDS will be deducted annually. In case of debt mutual funds, taxes are payable only when funds are redeemed or transferred.  

Says CA Mukesh Gupta, a certified financial planner, “During the holding period of debt mutual funds, no tax needs to be paid. This allows individuals to defer their tax payments to a later date.”  

He says that this feature preserves the benefit of compounding as the interest income remains in the fund. In contrast, bank deposits would lose a portion of their interest to taxation.

Reducing Tax Burden By Setting Off Losses

Debt mutual funds offer the advantage of setting off losses against gains. Short-term capital losses (STCL) can be set off against both STCG and LTCG in future financial years. This reduces taxable income and overall tax liability.

Let’s say you have a capital loss of Rs 40,000 from debt mutual funds and LTCG of Rs 60,000 from equity shares. By subtracting the capital loss from the gains, your taxable income for “Income from capital gains” would be reduced to Rs 20,000. This remaining amount would be subject to income tax based on the applicable rates.

Sometimes, the loss from debt mutual funds may be greater than the total capital gains. In such cases, you can carry forward the capital losses. Income tax laws allow individuals to carry forward STCL for up to seven assessment years (eight financial years) if the loss cannot be fully set-off in one year. These carried-forward losses can be set off against both STCG and LTCG from any asset in future financial years.

Higher Liquidity

In addition to taxation advantages, debt funds offer better liquidity than fixed deposits, with most types offering redemption within 24-48 hours without penalties.  

Government securities (G-secs) are currently offering high interest rates, and debt funds have yields that are 200 basis points higher than March 2022, so there’s more at stake than tax benefits.