Not all debt funds are bad even now

Use these for investment up to one year. Investors in lower tax bracket should choose the growth option

Budget 2014-15 had a lot of goodies for the aam aadmi. The increase in the tax exemption limit from Rs 2 lakh to Rs 2.5 lakh, the savings that can be done under Section 80C has been increased by Rs 50,000 per annum and the deduction available for interest repayment towards home loans for self-occupied property has been increased to Rs 2 lakh. But, there was a sore spot amid all the good news.

It was the change in the long-term capital gains tax and the tenure for qualifying for long-term capital gains for non-equity mutual funds. Long-term capital gains tax used to be 10 per cent without indexation or 20 per cent with indexation, whichever was lower. Now, the 10 per cent has become 20 per cent, effectively leaving only 20 per cent with indexation as the option. The other blow was the increase in duration from 12 to 36 months for being considered long-term.

HOW TO MANAGE YOUR DEBT PORTFOLIO

• Use liquid, ultra short-term funds for investment up to one year
• Open-ended funds are better than FDs for one-three years
• Surplus money can be kept in overdraft against home loan for any emergency
• Dividend option not suitable for those in the 0-20 per cent tax slab

Giving some respite to investors, the Finance Minister clarified, on Friday, that the higher capital gains tax on debt funds will not apply for redemptions made between April 1 and July 10. However, if you redeem after this date, the new tax rates will apply and so will the new definition of long-term.

These changes have lots of implications when we plan finances. Let us divide the tenures into three segments and analyse the impact. But do they make all debt funds bad options? Not really. Let us look at their impact by dividing the investment tenures into three segments.

One year or less: For a period of less than 12 months, investors can look at liquid funds or ultra short-term funds. These are suitable from the point-of-view of liquidity requirements and short-term provisioning. The attraction in these funds is that these can be cashed out when required and till that time they earn good returns. These funds might not have exit loads at all or may have exit loads for a short period of time, say a week to a month. Additionally, these funds have given about nine per cent or more annual returns, in the past year.

Taxation in the less than one year period was always at one's tax slab rate. That has not changed after the Budget. The other option for liquidity/short-term provisioning is keeping money in savings bank account. But that offers very low returns - typically four per cent pre-tax. Some banks give up to six per cent pre-tax, provided you maintain a certain minimum balance in the account. In most cases it is Rs 1 lakh and above.

Another option is to invest in short-term fixed deposits (FDs). Their returns are not very high - seven to eight per cent. Beside, they have a fixed tenure. If you want to withdraw before the end of the tenure, you will have to pay a penalty. This could mean lesser yield. Hence, for one year or less tenures, liquid funds/ultra short-term funds can be continued.

One to three years : The problems arise in this period. Before the budget, debt funds used to enjoy the long-term capital gains tax treatment here. Now, the tax treatment is as income. There is parity between FDs and debt funds in this tenure. Hence, in this tenure, debt funds are not hands-down favourites.

But hold on, there are reasons to consider debt funds even for this tenure. Debt funds were being used to provide for goals/expenses coming up in the near future. Many times, the timing of the expense is not clear. Hence, an open-ended fund would be a better bet as compared to one that has a fixed tenure like a FD. It can potentially offer somewhat better returns than an FD, where on premature withdrawal, the yield can be lower.

FDs would be suitable for those who want fixed returns. FDs will work well if the goal/provision is fixed and there is no possibility of a change there. However, if the goals get postponed, the FDs will mature and lie in the savings account, offering rather measly returns. This time period is a problem if we want to plan efficiently. We need to live with this uncertainty.

Three years or more : Investments done for this period are generally for the long term, to meet goals/funding requirements. In this tenure, long-term capital gains apply. Now, the long-term capital gains tax will be 20 per cent after indexation. Considering the inflation itself was at nine per cent in the past three years and indexation reflects that, the tax to be paid will be at best marginal. This was as it was before.

Planning through the OD account offered along with the home loan: Many banks today have an overdraft account (OD) attached to the home loan, where one can deposit the excess money one may have. For whatever money lies there, the bank will reduce from the principal for the purpose of calculating interest. This effectively means they save 10 per cent plus on the amount kept in that account. Hence, for those who have such OD accounts, liquid money can be kept there to take care of liquidity / goal requirements in the one to three year periods. This is one way of surmounting the problem posed due to change in capital gains tenure and tax in this budget.

Dividend distribution tax change: The dividend distribution tax has been amended to taxation on the gross amount to be distributed, instead of the net amount to be distributed, as was applicable till date. This effectively increases the taxation to 28.33 per cent from 22.1 per cent before, denting the effectiveness of a dividend option.

The other point to note is since the dividend distribution tax is at 28 per cent plus, it will not be suitable for those in the 0, 10 and 20 per cent tax slabs, as they would be effectively paying 28 per cent plus tax, when actually they are in the lower slabs. For such people, it would be better if they are in the growth option itself. Dividend option will, hence, be beneficial to those in the 30 per cent or higher tax brackets only.

Though there has been some turbulence in the debt fund space, it can be managed. The taxation in the one to three-year period has gone up and we need to live with it.

The author is founder, Ladder7 Financial Advisories