Following up on my previous article of 25th March (link: https://www.dineshgopalan.com/2023/03/change-in-tax-rules-on-debt-investments.html )
The changes will be effective from 1 April, 2023, for all investments made on or after 1 April. What this means is that if you invested anytime on or before 31st March, 2023, the old rules will apply even if you sell after 1/4/23.
Why has the government done this? Debt funds enjoyed an unfair advantage over bank deposits because of their tax treatment. This differential treatment has now been removed. This move was always on the cards – it was not a question of if, it was only a question of when.
There are three levels to any investment:
1. Protect principal, in other words, the risk element. Investments in government securities are better than investments in AAA corporates are better than investments in other companies and NBFC's are better than investments in risky companies, etc.
2. Protect against inflation. Inflation eats your money away. The "real" return of your investment is the return you get over and above inflation. You hope for at least a zero ( and not negative) real rate of return.
3. Get a real return. The return you get is proportional to the risk you are willing to take, at least in theory. Philosophically, this makes sense, and practically, this is where the whole subject becomes murky and subjective. How do you assess the risk? How do you decide whether the additional returns are commensurate with the additional risk? Anyway, everyone wants to have their cake and eat it too, but in most cases people struggle for their bread!
Debt is supposed to protect your principal and protect against inflation. It will never really give you a real return. The real return from debt will always range between plus or minus 2 percent. If it is anywhere above plus 2 percent, you need to be wary – there is likely to be additional risk involved.
The options for debt investments are, practically speaking:
1. Bank deposits and 2. Debt mutual funds.
We are ignoring PF and PPF in this discussion, since it is not a like to like comparison. Investing directly in corporate or NBFC deposits does give a slightly higher return than the above two options, but at a significantly higher risk, so that route is not worth it.
Even when it comes to debt mutual funds, choose only low risk funds which invest in the best quality paper – the extra percent or so that you get from funds that invest in riskier paper is not worth it.
All right, now that the tax arbitrage has been removed, what should one do?
The entire discussion assumes that the returns from debt MF's and Bank FD's are broadly the same which is broadly true (if you wonder why I am hedging in that statement, well, that is in the interest of being broadly correct!).
Advantages of Bank FD's: They are easier to understand.
Disadvantages of Bank FD's: You need to decide which bank and what tenor (duration of investment). The decision on tenor is not an easy one. Every time the FD matures, you have to remember to roll it over. Tax on FD is payable every year, even if it a "cumulative" FD not paying out periodic interest, thus reducing the effect of compounding. If you cancel an FD prematurely, you pay a penalty. If the Bank collapses, the Deposit Insurance covers you for only five lakhs; this risk can be mitigated by investing in highly safe banks which the government will ensure will not collapse, and by spreading your FD's across banks.
Advantages of Debt Mutual Funds: They are automatically diversified, since the investments are in a basket of companies and securities, and you can never lose all your money at once. Once you put the money in, you don't have to track maturity, reinvestment, etc. There is no TDS deduction as in banks, which, in my view, does not matter so much, but it does seem to matter to most people. The "capital gains" on sale can be set off against other capital gains and losses. You pay tax only on sale, and not annually.
So, the answer is clear. Debt funds are the way to go!
Well, but that is only the first step. A few additional pointers, that you need to keep in mind:
1. Do not invest in Funds that invest in riskier paper. The additional one or two percent is not worth it.
2. There is something called interest rate risk which even the safest of debt funds carry. ( see : https://www.dineshgopalan.com/2023/03/revisiting-investments-and-investing.html ). To avoid interest rate risk, it is better to invest in funds that invest in shorter duration paper, like liquid funds, ultra short, short duration funds, and money market funds. However the interest rate cycle is at or near the peak and this is not a concern for the immediate future. In case it looks like there will be an increase in rates at any point in time, one needs to pull out the investments from Funds that invest in longer duration paper and put them in the above mentioned Funds that invest in shorter duration paper.
Huh! I can see you staring at the above paragraph incredulously, thinking – yeh kya tamasha hai, no one tells me all this, and even if they do, I don't understand anything! Kucch samajh me nahin aa raha!
Well, I am sorry, but anything can be made only so simple as to make it understandable, but not so dumbed down that the content is lost. The subject is inherently complex, and I do not know of a simpler way to explain it.
The sum and gist? The advice? You may continue to invest in debt funds, in preference to Bank FD's. But that still does not absolve you from learning about them and keeping an eye on the market. But then that is true of life in general – nothing absolves you from knowing enough to safeguard your own interests.
Non-Finance people can stop reading at this point.
For Finance folk: d
These changes in rules are for funds that have less than 35 percent equity component. For funds with greater than 65 percent equity, equity rules apply for taxation purposes (15 percent for STCG and 10 percent for LTCG, no indexation).
For the funds holding between 35 and 65 percent equity, the rule continues to be: add to income and pay at slab in case of STCG ( less than three years); if greater than three years, that is, for LTCG, twenty percent tax rate with indexation of purchase price is still applicable!
Isn't that yummy? Even as a person with a reasonably good understanding of Finance, I find that my head it spinning. It is too early in the day, otherwise I would have poured myself a stiff peg of whiskey.
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