Tax liability bothering you? Invest in debt funds before March 31

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Debt funds are one of the preferred alternatives to fixed deposits. They had a good run last year with many of them delivering double-digit returns to investors. Currently, when the interest rates are expected to go up, the yields have started rising and experts say debt funds won’t be able to give as high a return as last year. As the interest rates go up price of papers in which debt funds have invested decreases, which lead to a decline in the net asset value (NAV).

There are various types of debt mutual funds, which you need to understand before investing. Based on the strategy, there are accrual funds, which earn interest income from coupon offered by bonds. Similarly, duration funds make a call on the direction of interest rate movements and then there are credit opportunities funds that invest in high-risk debt papers for the higher coupon.

You can also choose a debt fund based on the duration of your investment such as overnight funds, which have a maturity of one day. Liquid funds invest in securities having a maturity of up to 91 days and ultra short term duration funds invest in schemes with a duration of 3 to 6 months. Similarly, a gilt fund invests your money in government securities, among other things. There are also debt funds that invest for long term papers but they are considered risky given the movement in interest rates.

Tax Benefits

Debt funds have much lower tax liability when compared with fixed deposits in case the investment period is over three years. Long Term Capital Gains (where the holding period is over a three-year period) on debt funds are taxed at the rate of 20 per cent post indexation. Indexation help to reduce the tax burden. as for the purpose of tax calculation cost of purchase is adjusted for inflation using the Cost Inflation Index (CII).

But there is a one more way to optimise your tax savings. If you invest in a debt mutual fund investment near the end of the financial year with the holding period of 3 years makes you eligible for 4 indexation benefit.

Hence as this financial year is coming to a close you can consider investing in debt funds and get the indexation benefit of 4 years for the holding period of 3 years. This reduces your tax liability helping you earn a higher return when the yields are falling.