Last Updated on May 11, 2024 at 7:10 pm
A reader says, “Given the changes in debt fund indexation benefits, I come across market veterans recommending equity savings and multi-asset funds as alternatives. I have the SBI, Kotak and Parag Parikh conservative hybrid funds in three different portfolios in my family. Would you continue to recommend these conservative hybrid funds for a long term 10 – 15 yr holding for retirement and child’s folio for the debt component?”
Context: In a surprising move, the govt announced several amendments to the finance bill 2023. Among the changes is the change in taxation status for debt mutual funds.
Taxation status from 1st April 2023
- Funds holding 65% or more of Indian equity or Indian equity ETFs are equity funds (no change in this)
- Funds holdings less than 65% Indian equity but more than 35% Indian equity are non-equity funds (we will refer to these as class I). Gains from units purchased on or before 3Y are short-term gains and taxed as per slab, and gains from older units are taxed at 20% with indexation (no change in this).
- The big change: Funds holding less than or equal to 35% equity will be taxed as per slab regardless of the age of the unit. Let us call these class II non-equity funds. This will only apply to fresh purchases made from 1st April 2023.
So, what should investors holding debt funds do? Earlier, we noted that the SEBI MF categorization rules have several restrictions. It will not be easy for mutual funds to change the investment mandate of popular debt funds to lower the tax burden for investors. See: Will SEBI help investors and AMCs tackle the debt fund taxation rule change?
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And that has panned out to be true. Only new AMCs or those with few funds in their portfolios have been able to launch new funds. See: Quant Dynamic Asset Allocation Fund becomes an equity fund after debt fund tax rule change. And Can I invest in Balanced Hybrid Funds?
What are some tax-efficient alternatives for debt mutual funds?
How about Fixed deposits and recurring deposits? Should you change your investment strategy because of a change in tax rules? You can, provided it does not affect your portfolio strategy and risk level. 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.
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 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.
One instance where fixed and recurring deposits can play a bigger role 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, investing in a debt or arbitrage fund has no great tax benefit, and I can push fresh funds into bank deposits.
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 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. Since the reader is already invested in three conservative hybrid funds and hopefully used to some aspect of their risk and volatility, we recommend sticking with them.
Multi-asset funds? These are as risky as equity funds and certainly not a replacement for deb funds! See: Aggressive Hybrid Funds vs Multi-Asset Funds: Which are better?
For a full list, see: Which hybrid mutual funds are taxed with indexation benefits?
In summary, never choose a more volatile product only because it is taxed less! Arbitrage funds can be used as a tax-efficient short-term alternative to debt funds. Equity savings funds can be a tax-efficient long-term alternative to debt funds. However, these funds come with new risks and are suitable only for experienced investors. For the typical investor, we recommend sticking with your existing debt funds if you are comfortable with them.
Note: Readers who wish to create a list of funds with indexation benefits may consult our monthly debt and hybrid fund screener.
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