The Dividend Distribution Tax (DDT) on debt funds is expected to rise from 12.5% to 25%, similar to the existing structure of on liquid funds, from the June 1. Further, the surcharge on the DDT on both liquid funds and debt funds has been raised from 5% to 10%. These measures have been introduced in this year's budget to remove the tax arbitrage advantage that currently debt mutual funds have when compared to fixed deposits (FDs).
DDT is applicable to the dividend plans of debt funds, while capital gains tax is applicable to the growth plans of debt funds. From June 1, the new DDT (including the 10% surcharge and the 3% education cess) would be 28.325% for debt funds with dividend plans.

If an investor opts to invest in a debt mutual fund with growth option for less than a year, then the short-term capital gains tax would be based on the existing tax slab of the investor. If the investor opts to invest in a debt mutual fund with growth option for more than one year, then the long-term capital gains tax needs to be paid, which is lesser of 10% without indexation or 20% with indexation benefit (along with 3% education cess).

A key consideration for investors apart from the tax efficiency while investing is the anticipated return and the embedded risk. Currently debt funds, which are relatively more risky than bank FDs, give a 1-2% higher post-tax return compared to FDs. This outperformance of the debt funds is expected to continue in the medium term as, unlike FDs, the current trend of declining interest rates is expected to result in capital gains in debt funds.

From now on, the primary consideration of investors to choose debt funds over FDs would be the possibility of a higher return rather than the tax arbitrage, especially if the time frame of the investor is less than one year. If the investor has an investment time frame of more than a year, then a debt fund with growth option is currently best for investors as they could take advantage of the falling interest rates, which will get reflected in the form of capital gains in the debt fund and at the same time they would pay a much lower tax rate of 10.3%.

For shorter durations, typically less than a year, investors in the highest tax slab can still opt for dividend plans as the tax rate on dividend plans of debt funds is 28.325%, which is still lower than the 30.9% tax that investors get for investing in the growth plans of debt funds and FDs. Investors in the highest tax bracket can also invest in tax-free bonds as an attractive alternative option. Investors in the lower tax bracket should invest in debt funds with growth option and they should avoid investing in debt funds with dividend option as the post-tax return in the dividend option would be lower than the one from the growth option.