Make your investments more tax-efficient with these debt-oriented funds

livemint.com:

Subscribe to enjoy similar stories. Since April 2023, fresh investments in the growth option of debt mutual funds have been taxable at the marginal income tax rate for short-term capital gains (STCG). For most investors, this is 30% plus surcharge and cess.

The dividend option, now called income distribution cum capital withdrawal (IDCW) option, was already taxable at the slab rate. Investments made before 31 March 2023 in the growth option of debt funds were eligible for indexation for long-term capital gains (LTCG) taxation (holding period of three years or more). Then there was a twist in the tale.

The union budget presented on 23 July 2024 removed the indexation benefit. Now, you have to hold these investments for two years to qualify for LTCG tax of 12.5% plus surcharge and cess. The good thing here is that the union budget presented opened up two ways to improve tax efficiency.

We are talking about funds that are fixed-income-oriented and can be part of your debt allocation, but are not pure debt funds. You can hold these funds for two years to qualify for LTCG tax at 12.5% plus surcharge and cess. FoFs typically allocate less than 65% to debt – say 60% for the sake of discussion.

The remaining 40% in this case goes to arbitrage funds. These are classified as equity funds but make no directional calls on equities, meaning returns are not dependent on equity prices moving up. They earn returns from the differential, called the spread, between the price of a stock in the cash/spot segment and the futures segment.

In essence, this can be part of fixed income allocation. In arbitrage funds, the allocation to cash-futures arbitrage is usually 65-75% percent. The balance is in money-market instruments.