For a couple of weeks now, there has been a lot of buzz around debt fund taxation. At the same time, the interest rates on small savings schemes have been hiked by up to 0.7 per cent. As always, the leader of the small savings pack is the Senior Citizen Savings Scheme (SCSS), which will now pay 8.2 per cent compounded annually. The increase in the interest that the government pays in these schemes, coupled with the increase in the effective tax rate of debt funds for many savers, has somewhat changed the landscape for fixed-income savers.
Of course, while we all keep saying that the taxation on the returns savers will earn on debt funds will increase, this is not universally true. Technically, what has happened is that the gains you make on these for investments held for more than three years will not be taxed as capital gains but simply be added to your income. Earlier, these investments would have been taxed at 20 per cent after indexation. Now, they will be taxed at your income tax slab rate.
Notably, for many people, this will mean a reduction in the tax they will pay. I don't know the proportion; it's probably not discoverable anywhere. However, in general, tax slabs are a pyramid, and a pretty shallow one, meaning the number of taxpayers in any lower tax slab is always a lot more than any higher one. So how much will the tax impact be on the lower slabs? Let's take an example investment of Rs 10 lakh that, over the last three years, earned 7.5 per cent a year. Over three years, this would accumulate to a gain of Rs 2.42 lakh. With indexation, at a rate of 20 per cent, this would mean a tax of Rs 19,394, regardless of your income level.
Under the new scheme, those who are in the zero tax bracket of course, pay nothing, and debt funds will effectively become tax-free for them, like other forms of income currently are. Those who are in the 5 per cent tax bracket will see their tax reduced to Rs 12,100. Even in the 10 per cent bracket, the increase will be modest at less than Rs 5,000 a year. This is important, especially as many senior citizens fall in the lower brackets in many otherwise higher-earning families; senior and junior members' investments are carefully managed with this in mind. Earlier, everyone would have long-term capital gains tax at the same rate. Now, it is possible for the taxation to be lower, at least for some.
A comparison of the SCSS and debt funds looks straightforward on a hypothetical basis. All things considered, SCSS returns are in the same ballpark, probably about 0.6-0.8 per cent higher than mutual funds. However, the difference in taxation pattern (not rate) will make the advantage lean towards mutual funds. In all deposits, the interest will be added to your income every year, while in funds, it will accumulate till redemption.
Nonetheless, the fact remains that despite all these changes, you should not change your long-term investment strategy. Mutual funds offer benefits such as liquidity, deferment of taxation, and active management. For senior citizens, it's advisable to first exhaust the SCSS for guaranteed regular income and then allocate some funds to short-duration debt funds for emergency and liquidity purposes, as well as portfolio rebalancing.
While the changes to small savings schemes and debt mutual funds have garnered a lot of attention, they don't warrant a shift in investment strategy. Tax does not change the returns, liquidity, safety and other fundamentals of investments. Its role is secondary. Instead, the focus, as always, should be on long-term investing principles and maintaining a diversified portfolio created to meet your financial goals.
Suggested read: Is the debt fund tax a big deal?
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