Indexation Benefits on Debt Mutual Funds Removed: A Strategy to Manage Your Debt Allocation

Mar 30, 2023 / Reading Time: Approx. 10 mins

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As per the proposed changes in the Finance Bill 2023, which was passed in the Parliament amid continuous outrage by opposition leaders, the tax advantage on debt mutual funds for investments made on or after April 01, 2023, will no longer be available.

The indexation benefits on Long Term Capital Gains (LTCG) on debt mutual funds will be eliminated after March 31, 2023. Debt mutual funds will be taxed at the individual's marginal tax rate. For Debt mutual fund investors, the indexation benefit was a major draw. With the unexpected amendment in Finance Bill 2023 that eliminates this incentive, investors are debating whether a Debt Mutual Funds or a Fixed Deposit is preferable.

At present, investments in debt mutual funds over 3 years are treated as long-term capital gains and taxed at 20% with indexation benefits. According to experts, without indexation benefits, debt mutual fund investments would now be at par with banking and other fixed-income products.

[Read: Debt Mutual Funds are Now at Par with Fixed Deposits for Taxation]


Following the recent amendment to the Finance Bill 2023, long-term capital gains not only for debt but also for gold and foreign equity mutual funds will cease to enjoy the indexation facility, as they are treated as debt funds for taxation. This change in tax rule will be effective from April 01, 2023.

However, you still have a small window of opportunity to avail of the indexation benefit. Investors who invest in debt mutual funds before March 31, 2023, will thus be able to get the indexation benefit.

What is Indexation Benefit?

Indexation assists investors in lowering taxes by calculating them after accounting for inflation. Current tax laws allow an assessee (in this case, a debt fund investor) to calculate their LTCG tax due using the indexed cost of acquisition. This strategy considerably reduces taxation, especially in an inflationary climate. This factor was a major draw for investors to invest in debt mutual funds.

For example, if you buy something now for Rs 100, it will be worth slightly more in a few years. Indexed cost of inflation considers annual inflation and calculates a formula to raise your cost price correspondingly. In other words, indexation assists in adjusting the investment amount against the Cost Inflation Index (CII) value of purchase and sale for the fiscal year, lowering the tax burden on investors.

Indexation Benefits on Debt Mutual Funds Comes to End: How to Manage Debt Allocation in Your Portfolio?
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What is the purpose of this amendment through Finance Bill 2023?

This approach by the government is based on a number of factors, one of which being that debt funds offer extremely strong indicative returns and nearly no credit risk, thus they have a very predictable return and should be handled in the same way as a fixed deposit and not given preferential treatment. This is strange because debt funds still bear interest rate risk and default risk. Those that invest in debt funds are investing in a market link product, as opposed to fixed deposits, which offer fixed returns.

According to market experts, the goal of the government's decision appears to be to reduce arbitrage.

The suggested adjustments are consistent with the principle of the new default personal income tax regime without exemptions. India's tax policy is evolving towards a basic, consistent tax structure with no possibility for tax exemptions or arbitrage.

What will be the impact on retail investors?

You see, this end of indexation benefit on debt mutual funds will mostly affect those investors who rely significantly on debt funds for long-term investments, as well as those looking for a very safe investment option with low risk and high tax advantage.

Long-term debt funds may see outflows as a result of changes to the LTCG tax on debt mutual funds. Investors will not retain debt funds for 3 years; they will consider exiting investments at any moment after achieving capital gains and paying the capital gain tax based on their income tax bracket.

For investors having more than 3 years horizon, debt schemes were better vis-a-vis FD (Fixed Deposit) in higher tax brackets. While FD always has the element of the return being known upfront as the rate of interest is fixed, debt funds have the taxation edge due to the above rule. However, now with the proposed change in tax rules, Fixed Deposit and Debt Mutual Funds are at par with each other in taxation. FD carries the additional advantage of being free of interest rate risk, while debt funds carry the interest rate risk.

Many investors, especially the ones with high tax brackets, may consider a gradual shift from long-term debt funds to equity funds, with funds allocated towards sovereign gold bonds, bank fixed deposits, and non-convertible debentures in the debt category now.

Having said that, pure debt funds will lose their attraction over fixed deposits as far as tax benefits are concerned. However, on the contrary, some experts believe that debt funds will continue to outperform FDs due to people's realisation that there are no other viable options available. There has been no policy adjustment that has made Fixed Deposits more appealing. Professional management, liquidity, and diversification remain significant advantages for Debt mutual funds.

What should be your debt allocation in your investment portfolio?

The unexpected action by the government to change the taxation of debt fund gains has surprised mutual fund investors and the sector. Your previous debt investments will not be affected since these adjustments will be implemented for fresh investments made from April 01, 2023, onwards.

Despite the tax benefit ending on March 31, 2023, mutual funds will still offer several advantages over traditional fixed-income avenues. A well-diversified portfolio with very high regulatory oversight, the highest disclosure standards, a large variety of solutions across the liquidity, duration and credit spectrum, and active and passive solutions give debt mutual funds the edge.

But nonetheless, investors must be aware of the volatile nature of the financial market and debt schemes. As a result, rather than making investment decisions primarily on external circumstances, it makes a lot of sense to prioritise your risk profile and financial goals while investing. Your allocation to asset classes such as debt, equity, and gold should ideally be based on your financial goals and future cash flow requirements. As a result, if you already hold debt mutual funds in your portfolio, it's better to stay away from premature redemption just in response to this tax regulation change. Anyways the old investments are not impacted due to this rule.

Tax benefits are provided in several mutual fund schemes, but it should not be the primary reason for your investment in debt funds. Your investments are aligned with your objectives and should remain so, the taxation impact shall be secondary. In a nutshell, you should avoid herd mentality and extreme action of panic redemption. Preferably you can be pre-emptive with fresh investment in debt mutual funds, ensuring that they are aligned with your goals and the duration required to reach them.

MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.

She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.

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