How Debt Funds Can Help In Saving Income Tax

Every year people pay a hefty sum as income tax and are almost on the lookout for cutting a slack on that. Although paying income tax is the duty of a responsible citizen, there is absolutely no harm in curbing it in the most lawful manner.

People who are required to pay tax in millions, intend to rather reinvest the money. Investing in debt funds is the most popular and effective way to save a considerable amount of your income tax. 

Introduction to Debt Funds

Companies often borrow from investors when they have to raise funds for their own commercial needs. In return, they provide the investors with regular interest on the borrowed sum. This is called a debt fund.

An investor buys a debt by lending money to the issuing entity, investing in securities such as government securities, corporate bonds, commercial paper, treasury bills, and other money market instruments. 

The interest rate and the amount that you will receive at the end of your maturity will be previously decided by the issuers of the debt fund. Debt funds investing in higher-rated securities are less volatile than the ones that are of low rated security.

Investments made in high rated credit instruments often turn out to generate regular interest on the debt security as well as the final principal amount at the end of its term. 

How Debt Funds Affect Your Tax Benefits

The gains that an investor is entitled to, via debt funds, are subject to taxation. The rate is however based on the holding period which is the term of your investment in the debt fund. A capital gain could be of two types:

• Short term capital gain: STCG is the gain made during a period which is less than three years.
• Long term capital gain: LTCG is the gain made during a period which is more than three years. 

Investors can add their capital gain from the debt funds to the income. A 20 percent tax after indexation is applied for capital gains from debt funds. This indexation will play a determinant role in lowering your income tax liability.

Therefore, debt funds are among the most tax-friendly investments. Let us now explore the aspect of tax in debt funds a little more.

The short-term capital gains whose units are sold before three years are taxed as per the tax rate that is applicable to the investor. Suppose your tax rate is 30 percent, in that case, your STCG tax would be 30 percent plus 4 percent cess.

On the other hand, the long-term capital gains are taxed at the rate of 20 percent with indexation as previously mentioned. This indexation factor is liable for the triumph of debt funds over bank fixed deposits and other smaller schemes. 

Debt funds are a great and better alternative for your fixed deposits.

Types Of Debt Funds

Debt funds are suitable for both short as well as long term investors. One can invest for as short as three months or one year to a comparatively longer period. Thus debt funds come in various types to cater to investors of varying kinds.

For short term investments, a liquid debt fund may be ideal while on the other hand, for a medium-term investment, dynamic bond funds are ideal. Monthly income plans are another good option for a steady income from the investment. 

Let us study further about the types:

1. Income Funds

These funds invest essentially in debt securities which have extended maturities. They are more stable than fluctuating funds with the maturity of funds ranging from 5 to 6 years.

2. Gilt Funds

Gilt funds work with very low or nil credit risk since they invest solely in high rated government securities. This is the best option for risk-averse investors.

3. Credit Opportunities Funds

These funds are risky because they do not invest according to the maturities of debt instruments but rather endeavor on earning superior returns by taking credit risks or by holding bonds that come with high-interest rates.

4. Liquid Funds

Liquid funds are the most risk-free ones as they invest in debt instruments that come with a maturity of a maximum of 91 days. These funds have seldom witnessed negative returns. These are a great option for people looking for a short but fruitful investment. 

5. Dynamic Bond Funds

These funds are among the volatile ones because the fund manager does not keep the portfolio composition stable and keeps altering them as per the interest rate which itself keeps fluctuating. Both short term and long term investments can be made under this fund.

6. Fixed Maturity Plans

Fixed maturity plans are debt funds that are closed-ended. These funds invest in fixed income securities. These are largely favored by one looking for a long term investment. 

7. Short-term and Ultra-short Term Debt Funds

These funds invest in instruments that have shorter maturities anywhere between 1 to 3 years. Conservative investors find this type of funds best suited. Interest rate movements do not affect them much.

Shun old low return investment schemes and invest in debt funds to get higher returns and to cut back on your income tax. Always remember that relaxation on the income tax is also a form of income. 

8. Corporate Bond Funds

Corporate Bond Funds are those funds that invest at least 80 percent of their corpus in highest-rated corporate bonds. These have a good chance of a higher return than those provided by debt funds that are short term.

Factors to keep in mind before investing in Debt Funds

1. Investment Period 

Before investing, always decide on the investment tenure you have in mind. If it is less than 1 year, liquid funds and ultra short-term funds are advisable. As a rule, the higher the tenure, the more are the returns.

2. Investment Goal

Investors also use debt funds as a means to supplement income over salary, source of income during retirement, or for liquidity purposes!

3. Risk

Debt Funds carry a lower risk than equity funds. However, they are not immune to credit and interest-rate risks. If a fund manager invests in a low-credit quality bond, then they carry a high credit risk.

The value of the portfolio may go down due to delay or default in payment of interest and or capital. 

4. Fees

Debt Fund managers charge a fee to manage investment portfolios. This fee is called the expense ratio.