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Things to know about debt funds
Debt funds offer several advantages but small investors know little about them. Here's how you can benefit from them.
TAX RULES HAVE CHANGED
In this year's Budget, the tax rules for debt funds were changed. The minimum tenure for long-term capital gains was extended from one to three years. This means that investors will have to remain invested for at least three years if they want the benefit of lower tax on long-term capital gains. If redeemed within three years, the gains will be added to the person's income and taxed as per the applicable income tax slab. However, if the investor can hold for more than three years, a debt fund will be far more tax-efficient than a fixed deposit. In a fixed deposit, the entire interest earned is taxed at the rate applicable to the investor. The long-term capital gains from debt funds are taxed at 20% after indexation. Indexation takes into account inflation during the period that the investment is held by investor and accordingly adjusts the buying price. This can lower the capital gains tax significantly.
KEEP IN MIND THE EXIT LOAD
A debt fund is very liquid since you can withdraw your investments at any time and the money is in your bank account within a day. However, some funds levy a penalty for exiting before the minimum period. The exit load can vary from 0.5% to 2%, while the minimum period can range from six months to up to two years. Check the exit load of the fund before you invest. Even a 1% exit load can shave off a significant portion from your gains.
NO TAX DEDUCTION AT SOURCE
Another tax-friendly feature of debt funds is that there is no tax deduction at source (TDS) on the gains. In fixed deposits, if your interest income exceeds `10,000 a year, the bank will deduct 10.3% from this income. If you are not liable to pay tax, you will have to submit either Form 15H or 15G to escape TDS. The other problem is that the income from fixed deposits is taxed on an annual basis. You will get the money once the deposit matures, but the income is taxed every year. In debt funds, the tax is deferred indefinitely till the investor redeems his units. What's more, the gains from a debt fund can be set off against short-term and long-term capital losses you may have suffered in other investments.
RETURNS ARE MARKET-LINKED
Though they are looking very promising, debt funds do not offer assured returns. In fact, they can also churn out losses in case the interest rates go up, although the possibility of this happening is remote. The maturity profile of the holdings defines the volatility of a debt fund. Funds holding short-term bonds are not very volatile and give returns roughly equivalent to the prevailing interest rate. But the funds that invest in long-term bonds are more sensitive to changes in interest rates. If rates decline, the value of bonds in their portfolio shoots up, leading to capital gains for the investor. While the average short-term debt fund has given 9.8% returns in the past year, some long-term bond funds have shot up by 1415% during the same period.
INVEST IN SIPs VIA DEBT FUND
Financial planners say one should not invest a large sum in stocks at one go. Instead, SIPs are the best way to buy equity funds. If you have a large sum to invest, put it in a debt fund and start a systematic transfer plan to the equity fund of your choice. Every month, a fixed sum will flow out from the debt fund into the equity scheme. Compared to the 4% your money would have earned in the savings bank account, it has the potential to earn 9-10% in the debt fund. Similarly, if you want regular retirement income from your investments, invest in a debt fund and start a systematic withdrawal plan. Every month a fixed sum will be redeemed from your investment.
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