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Should you invest in a debt fund with a three year horizon?

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Debt mutual funds | Are debt funds advisable for a 3 years time horizon?

Is debt fund an advisable option to invest for three years horizon? - Akshay Jha

In short, yes. Let us explain.

Debt funds tend to be more tax efficient compared to fixed deposits (FDs) which are a preferred option for people when they have a definite time horizon.

However, the interest that you earn on FDs is taxed on an accrual basis. This means even if you don't make a withdrawal of the interest, you still have to pay tax on the interest 'earned', as per the applicable slab.

Whereas in debt funds, the tax liability arises only when you make a withdrawal. If an investment is sold within three years, the gain is added to income and taxed as per the slab. Otherwise, it is taxed at 20 per cent after providing the benefit of indexation. Since the benefit of indexation is available only after three years, the real benefit of investing in debt funds arises only when they are held for more than three years.

Post-tax returns can be higher for those who invest in an FD, especially for someone in the higher tax brackets. Let's assume you fall in the 30 per cent tax bracket and you invest Rs 15 lakh in a three-year FD and the same amount is invested in a debt fund.

Suppose both investments earned you a 7 per cent return per annum for three years. At the end of the third year, you end up with Rs 18.37 lakh making your capital gains to be Rs 3.37 lakh. Since your holding period is beyond three years, you have the benefit of indexation when you sell your debt fund.

After adjusting the purchase cost, (read more about it here), our gains reduced to Rs 1.19 lakh from Rs 3.37 lakh (Rs 15 lakh adjusted to Rs 17.17 lakh (Rs 15 lakh x 331/289). A 20 per cent tax will make your liability to be Rs 23,914.

Whereas when it comes to FDs, the tax liability is based on the income tax slab you fall in. if you fall in the 10 per cent category, then your tax liability will be Rs 33,756 - which is about Rs 9,800 more than the debt fund's tax amount. But if you fall in the 30 per cent category, your tax liability jumps to Rs 1.01 lakh - which is about Rs 77,000 more than the debt fund's tax amount.

If you go for the debt fund, you would save a lot of money at the time of paying tax - especially if you fall in a higher tax bracket. An FD could be beneficial only for investors falling in the lower tax bracket of 5 per cent or for a senior citizen who hasn't exhausted the Rs 50,000 limit under Section 80TTB of the old tax regime. However, one must consider the additional benefit of indexation and the possibility to earn higher returns in the case of debt funds.

Suggested read: Is it a good time to invest in an FD since interest rates are rising?

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