Reduce Tax Outgo & Also Increase returns by upto 2.5% On Debt Funds

In the month of march, we see investors parking their surplus funds in fixed maturity plans and scores of other debt funds, to take advantage of double indexation benefit. But, the series of policy rate cuts by reserve bank of India and increased the expectation of capital appreciation on these investments. 

 Advantage of double indexation can be had by investing in March of year 1 (FY 2012-13) and then selling in April of year 3 (FY 2014-15). This virtually brings down the tax impact to a very low level if not to zilch. This means whole yield on such investments becomes tax free.

A rate cut will result in capital gains on these instruments.

A debt fund with 5 years average maturity could give you a capital appreciation of 250 basis point, or 2.5%, if interest rates were to drop by 50 basis points, or 0.5%.

That means, good days are ahead for debt fund investors in the coming year. If repo rates were to be cut by 1% you would get accrued interest of about 7.8% plus 5%, pushing up your effective rate of returns to 12.8%. In case repo rates are cut by 50 basis points, your total returns could be approximately 10.3%.

How does double indexation work

Double indexation would kick in if you invest in the first financial year and sell in the third financial year. So if you invest now in March 2013 (financial year 2012-13) and sell your investment in April 2014 (financial year 2014-2015), you can get the benefit of double indexation. This may help you to reduce your tax liability on long-term capital gains that will arise on redemption of mutual funds.

Let us take a simple example:

Suppose you invest 1 lakh in a debt fund in March 2013, with say an average portfolio maturity of five years. Now, you will get accrued interest of approximately 8% on this investment.

Assuming repo rates are cut by 50 basis points conservatively during the year, you can see a capital appreciation of 2-2.5%. So if you redeem the investment in April 2014, the total return will be approximately 10-10.5%.

Now, as per tax laws, you have the option of paying tax on long-term capital gains with or without indexation. Assuming a 10% return on your investment, your total fund value will be 1,10,000 (investment 1,00,000 and a capital gain of 10,000) in April 2014 .

Now the tax calculation works as follows: The CII (cost inflation index) for the year 2012-13 is 852. Assuming 7% inflation, for the next two years, the CII for 2013-14 will be 911 and that for 2014-15 will be 975.

If the debt fund is redeemed in April 2014, you can also take into account the CII of 2014-2015. Capital gain with double indexation in this case will be 1,10,000 - 1,14,437 = (-) 4,437. Thus, as per the calculation, you make a loss of 4,437. That means you will pay zero tax, or your returns are tax- free. In fact you can even carry forward this loss for eight years and can set it off against long-term capital gains.

What Are The choices You Have

For risk averse investors, who have invested in the debt market in March this year could be fruitful.

With both benefit of indexation and capital appreciation, this is a good opportunity for debt investors to get double-digit tax free returns.

Debt Fund category provides investors a number of products to choose from. Investors looking for capital appreciation plus benefits of double indexation can go for income funds, dynamic bond funds or gilt funds.

Dynamic Bonds are best suited for Investors with a time frame of more than a year. Here, the fund manager can change the maturity of the portfolio based on his assessment of the interest rate scenario. In this type, the fund manager actively manages the duration of the fund. He takes his decision based on the interest rate environment.

Therefore, the fund manager's view would be reflected by the maturity profile of the funds and its duration.

Typically, the duration and average maturity would tend to be longer if the fund manager feels that interest rates are likely to fall, or are falling. Birla Sun Life Dynamic Bond Fund, SBI Dynamic Bond Fund, Reliance Dynamic Bond Fund, IDFC Dynamic Bond Fund are some of the funds in this category.

Investors who merely want the benefits of double indexation and no interest rate risk, can opt for a fixed maturity plan (FMP). However, the returns on these would be under 9.5%.

A Note Of Caution:

It is very important for the investor to take, not only a right decision at the right time; but, also execute it. Wealth Management is all about timing well managed. Just because an investor is not aware of policy rate cut, and the funds that need to be acted upon at an immediate point in time, might loose the opportunity to have a double digit return.

Not only this, in the falling interest rate scenario funds being in the ultra/short term funds will see a fall in returns, a reverse trend to what would be seen in the long term debt funds.

Also, a critical point comes, if policy rate are revised upwards. The whole strategy has to change.

Thus, it is imperative that a investor has his funds being managed by a specialist firm, whose expertise is in pure wealth management; with state-of-art transactional platform (No Cheques involved). There higher chances of opportunity loss when you have to shift funds between different mutual funds firms (Asset Management Companies). 

Last but not least, you advisor should be an advisor in the true sense and deed, and not with a trader bent of mind. he should be knowledgeable enough, and be able to implement his key thinking so that the returns for the clients are maximized.