Several readers have asked us how their investment strategy should change due to the change in debt mutual fund taxation rule applicable from 1st April 2023 on fresh purchases.
This is our topic coverage with all the details: Debt mutual funds to be taxed as per slab from 1st April 2023! And Will SEBI help investors and AMCs tackle the debt fund taxation rule change?
Should you change your investment strategy because of a change in tax rules? You can, provided it does not affect your strategy. Many investors claim they will now switch to fixed and recurring deposits even for long term goals because there is no reward for taking risks with debt mutual funds. With bank deposits, at least the return is known beforehand.
At first sight, this seems logical. However, there is more to investing than choosing instruments. Bank deposits are not liquid mid-term – at least not without penalty. So those who are serious about asset allocation and rebalancing will have to pay this penalty if they switch from debt funds to bank deposits.
I would wager most investors who make this switch are unlikely to rebalance, fearing this penalty. So the risk in the overall portfolio could increase.
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Over the long term, say, ten years or more, a suitable debt fund (gilt funds or corporate bonds, for example) has a reasonable chance of beating a fixed deposit before tax. Since we pay tax only on redemption in a mutual fund, unlike a bank deposit which is taxed annually, the post-tax debt fund is also likely to be higher. Of course, there are no guarantees, but the risk is reasonable enough.
How about investing in arbitrage funds instead of debt funds? Arbitrage funds are unsuited for long-term investment as the returns may be similar to a liquid fund pre-tax. Also, arbitrage opportunities have considerably decreased in the Indian markets due to greater participation. Such funds can be used for the short term but with no great return expectation.
How about switching to an equity savings fund? These come with considerable risks and unknowns in investment strategy. They should never be used for the short term. See: Equity “Savings” Funds meant as short-term investments suffer huge losses
Yes, informed investors can consider these as a tax-efficient alternative to long-term debt funds for the long term, but do not expect a smooth ride.
One instance where fixed and recurring deposits can play a bigger role now is in de-risking a long-term portfolio. Readers may know I regularly rebalance my son’s future portfolio from equity to debt. So far, I have used arbitrage funds and gilts funds for this purpose.
This was an 18-year goal when I started, and now it is a five-year goal. So from April 1st 2023, instead of investing more in gilt funds, arbitrage funds, or Parag Parikh Conservative Hybrid Fund, I can open an RD that matures in five years. I can push future redemptions from equity to a fixed deposit. Please note that this is “okay” because I am in the de-risking (equity reduction) phase. Over five years, there is no great tax benefit in investing in a debt fund or arbitrage fund and I can just push fresh funds into bank deposits.
What about international funds? That depends on why you wanted to invest in them in the first place! If you want a piece of something shiny, then it is just portfolio clutter, and what you want to do now matters little unless you are serious about a proper investment strategy. If you wanted “international diversification”, you have been enjoying the true benefit of diversification in the past months!* So you can continue.
* Diversification will lower investment returns!
As reported yesterday – Will SEBI help investors and AMCs tackle the debt fund taxation rule change? – we expect fund investment mandates to change. So if you are lucky, your funds will still be taxed at 20% with indexation. So do not make any hasty decisions. Wait for some clarity. Until then, you can put off investments in debt funds.