How cost inflation index helps reduce your debt fund taxation

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Back on June 15th, the Central Board of Direct Taxes (CBDT) notified the Cost Inflation Index (CII) of the financial year FY 2021-22 as 317, against 301 for the previous year FY2020-21. This 5.32% spike marks a change from the lower revisions in earlier years. 

cost inflation index

The Cost Inflation Index reflects the rate of inflation. High inflationary years typically see a high Cost Inflation Index and vice versa. But why are we talking about the Cost Inflation Index at all? The Cost Inflation Index is used in calculating the present value of your historical investment costs to arrive at capital gains. So, taxation of any investment that enjoys indexation will involve the Cost Inflation Index. Cost Inflation Index, therefore plays a major role in the returns you get from your debt funds. And it also differentiates the net returns you earn from debt funds as opposed to the post-tax return on your FDs. The higher Cost Inflation Index rate at present, brings the effect of tax on returns between bank fixed deposits and debt funds into greater focus now. Let’s see how this difference stacks up.

Taxation of bank deposits and debt mutual funds

A bank FD is taxed during the course of the investment, while a debt fund is taxed only at redemption.

Interest from your bank FD (or any other FD) is added to your income for every financial year. Even if you have a cumulative deposit - the interest is assumed to be earned every year and taxed in that year. The tax you pay on your FD interest is at the tax slab to which you belong. So, if you are in the 20% tax bracket, you will be paying 20% tax on FD interest. If you’re in the 5% tax bracket, it will be 5% on FD interest.

In a debt fund, you pay tax on the capital gain only at the time of sale of your units. The capital gain is the difference between the cost of investment and the sale value. Capital gains from debt mutual funds are taxed based on the duration of the holding period. If the units are sold in less than 3 years, the capital gains are added to your income and thus taxed at your slab rate. Therefore, they are similar to FDs in short-term periods (debt funds still have a tax advantage over FDs if you use the SWP method to derive income from them. We will write about this in a separate article) 

If your debt fund units are sold after the completion of 3 years, the capital gains are taxed at a flat rate of 20% after indexation. And that’s where there can be a world of difference between post-tax returns of an FD and a debt fund. 

In an FD, you are paying tax on the interest component at your slab rate, every year whether cumulative or not. But here’s how it stacks up with debt funds:

  •  In a debt fund, you pay tax only when you redeem. 
  • Next, you pay 20% tax on your capital gain, regardless of your slab rate. And most importantly, you are allowed to inflate your costs (using Cost Inflation Index) to bring it to the current value of money. In other words, you are allowed indexation benefits.

How does indexation work?

Like we mentioned earlier, indexation allows you to bring your historical investment cost to today’s value, using inflation as a yardstick. As a result of this, your cost becomes higher and therefore your net capital gain (sale value less indexed investment cost) is lower. You pay 20% of this capital gain. Therefore your tax impact is lower.

Illustration

Suppose you are in the 30% tax bracket and invested Rs 1 lakh each into a 3 year FD and a debt mutual fund 3 years ago in 2018 January. The SBI 3 year FD interest rate was 6% per annum in January 2018. Using the average returns of short duration and banking & PSU for the debt funds and applying indexation to the capital gains, we can compare the tax treatment as below:

Post-tax value = invested value + total interest credited - total tax paid

Note: Credited interest will be slightly higher than the per year rate as banks will compound interest quarterly.

For simplicity, cess and surcharge on tax are not considered for calculation.

Average returns for the Banking & PSU debt and Short Duration category were 6.71%, 7.74%, and 9.96% for the years 2018, 2019, and 2020 respectively.

Note: for simplicity, cess and surcharge on tax are not considered for calculation.

What does history say?

Now that we’re aware of how different taxation works for FD and debt funds, let’s look into the historical post-tax returns from both bank FD and debt funds. We’ve taken a 3-year period to illustrate the lower tax impact that debt funds can have, since that’s the minimum number of years you’d need to hold for indexation benefits. We have chosen the average return of short duration and banking & PSU debt fund categories, as it is the most representative for a 3-year holding period. 

The below table shows post-tax returns from both SBI 3-year FD and debt fund.

*10% tax slab was replaced with 5% tax slab starting FY2018. Post-tax returns for the slab are calculated accordingly.

Bank FD returns are as per the historical SBI 3-year FD rates.

Debt fund returns are historical average returns for the category banking & PSU debt and Short Duration funds.

This tells us that there are three factors at play - one, the FD interest rate, two, the inflation and Cost Inflation Index revisions, and three, the tax slab.

  • In periods where FD rates are high, locking into these high rates can be a better option if you’re in lower tax brackets of 5% or 20%. FD rates in 2009, for instance, stood at a good 7-8.5%.
  • In high inflationary periods, though, debt funds can serve up better post-tax returns. Elevated inflation can peg up the Cost Inflation Index, which helps reduce the tax impact on debt funds. While FD rates as such may be high, the indexation benefit that debt funds provide can outstrip the superior FD returns for those in higher tax brackets.
  • The indexation benefit that debt funds offer should not be ignored. Even should debt fund returns lag FD rates (which can happen when FD rates are high) the tax paid on FD interest can eat into a large part of the gain.

What this means for you

Typically at the top of the interest rate cycle, FD investors benefit from long-term deposits. This is because they were able to lock in the higher interest rates for the entire duration. 

Currently, both bank deposit rates and debt fund yields are at historical lows. Therefore, locking into FDs now for longer-term periods will not help; the tax impact would dent returns still further. 

Debt funds, though, would suffer a lower tax impact. Further, these funds would be able to adapt their portfolios to pick up debt papers with higher interest rates should the cycle turn higher. This can help push yields up and improve returns further down the line. 
Debt has a role in wealth preservation in the portfolio. Occasionally, due to poor market rates or high inflation, or both, you may not be getting meaningful returns from this asset class. However, this is no reason to become adventurous by loading up on debt funds. Debt funds do not provide fixed/assured returns like FD. There’s a place for both bank fixed deposits and debt funds in your portfolio. At times like these, you can avoid starting new fixed deposits for the long term. Continue to hold debt instruments that match your investment objectives (see prime funds). Similarly, if you are in the high tax bracket, some amount of debt funds can help reduce your tax impact.

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7 thoughts on “How cost inflation index helps reduce your debt fund taxation”

  1. Does it make sense for someone in the lowest tax bracket (like a young employee or a retired person) to invest in debt funds if their horizon is 3 – 6 years?

    1. At these interest rates – yes. But even otherwise, it is good to have allocation to debt funds, in addition to FDs because they can deliver higher returns. Two, unless there’s a redemption there’s no tax that’s paid. In FDs, remember that you pay tax every year, even if it is low. And if, as a retiree, you are using the debt fund to run SWPs for cashflows, then debt funds score better than FDs. That is covered here: https://primeinvestor.in/swp-a-low-tax-option-to-generate-income/ – thanks, Bhavana

  2. Can you also please share your thoughts on OverDraft and Loan against securities? Differences and which is better please? Also would other considerations such as Redemption period (In FD, it would be instant. And in Debt, it would be T+1 or T+2) have an impact on the decision?

  3. Thanks ! If you could write an article on SWP method for deriving income with tax advantage will be most beneficial for retired persons like me.
    Regards,
    SWETHARANYAN

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