New Debt Mutual Fund Taxation Rules: Should you Continue investing?

New Debt Funds Tax Rules: Should you Stop investing in Debt Mutual funds?

Since the announcement of new debt mutual fund taxation rules, kicking off from 1st April, 2023, I have been receiving queries from various investors, particularly those who come under high tax brackets.  

They would like to know if they should stop their debt fund SIPs from 1st April and start parking money in Bank FDs/RDs, even for the long-term goals? Banks are offering attractive interest rates too!. Read more: What is SIP in Mutual Funds?

Yes, one of the biggest advantages of debt mutual funds over bank FDs was the indexation benefit and a flat tax of 20% on the gains, if held for 3 years or more. 

As an amendment to the Finance Bill, 2023, this favorable tax treatment towards debt funds is being withdrawn by the government to bring the taxation of all fixed-income securities at par.

But, in some aspects, debt mutual funds are still better than Bank FDs. In this post, let us understand why you should continue to invest in debt funds even after the change in the tax rules?

Let us start by understanding the new debt fund tax rules.

What is the new Debt mutual fund taxation rule 2023?

Prior to 1st April 2023, the gains from debt mutual funds after three years of holding period were considered long-term capital gains and were taxed at a flat rate of 20%. In addition, indexation benefits were also provided, i.e.,the purchase price is indexed in-line with the inflation in the economy (taking Cost Inflation Index numbers as the base). This reduced the amount of tax paid on the gains from debt mutual funds even further.

The new debt fund tax rules have taken away these advantages. 

Now, the gains made on selling the debt fund units purchased after 31st March 2023 would be added to your income and taxed on the basis of the income tax slab you fall under. However, the existing investments (up to 31st March 2023)  will be taxed at 20% and will continue to enjoy the indexation benefits.

In short, irrespective of the holding period of your investment, gains made on debt funds (bought after 31st March 2022) would be treated as short-term capital gain and taxed accordingly.

Not only debt funds, the amendment says, all funds with an exposure of 35% or less to Indian equities would also fall under the purview of this new rule. It means, apart from debt funds, the tax rules would also be changing for the following categories of mutual funds:

  • Gold Funds
  • International Funds
  • Target Maturity Funds
  • Conservative Hybrid Funds
  • Fund of Funds 

Read More : Target Maturity Funds: Is Passive debt Investing a good Strategy?

More tax on debt funds:

Yes, that’s right. Now, with this new debt mutual fund taxation rule in place, you have to pay more tax on debt mutual fund gains, particularly if you belong to the higher income tax slab of 30% plus. Let us take an example to understand how much the tax difference is.

Assume that you have invested Rs.5 Lakhs in a debt fund, held it for more than three financial years and have made a gain of Rs.1.20 Lakh on your investment. So,the total value of your investment at the end of three years is Rs.6.20 Lakhs. 

Under the old tax rules, considering the indexation benefit, for instance, your cost of purchase inflates from Rs.5 Lakhs to Rs.5.60 Lakhs. So, your taxable gain reduces from Rs.1.20 Lakhs to Rs. 60,000 (6.20 Lakhs – 5.60 Lakhs), on which you need to pay tax @ 20%. So, the tax you pay on the gain of Rs.1.20 lakhs is Rs.12,000 (approx.). 

Under the new debt funds tax rules, the whole gain of Rs.1.20 Lakhs would be added to your income and taxed as per the slab rate. Therefore, if you belong to the 30% income tax slab rate, you will pay a  tax of Rs.36,000 (approx.), almost 3 times more. 

This rule has made the taxation of debt mutual funds at par with bank fixed deposits.

Does it make sense to continue investing in debt mutual funds?

The answer is Yes. It still does. Apart from the favorable tax treatment, there are various other advantages that debt mutual funds hold in comparison to bank FDs. These are as below:

  1. Partial Withdrawal Flexibility:

Partially withdrawing money from bank FD not only reduces the interest rate but also attracts penalties. For instance, if you have booked a 12-month FD and want to liquidate the FD after 3 months, the Bank would provide the rate applicable on the 3-month FD. In addition, it may deduct a portion of it as a penalty for premature withdrawal. There is no such issue with debt funds. You can liquidate your investment anytime you want at the prevailing NAV of the fund. You will neither lose on returns, nor pay any penalties.

  1. No tax on accruals:

In the case of Bank FDs, you have to pay tax on the entire interest accrued in the financial year whether you use it or not. It is subject to TDS as well. It is not the case with debt mutual funds. The tax liability on the gains from these funds occur only when you redeem the units and realize the gains. Read more : Form 15G and 15H: How to Avoid TDS on Interest income?

  1. Better Compounding:

Since tax on debt mutual funds is applicable only at the time of redemption, you can reap the benefits of compounding on your investment, to the fullest. For instance, if you put Rs.100 in Bank FD at an interest rate of 7% p.a., after one year the corpus becomes Rs.107. Out of this, you need to pay Rs.2.10 as tax and in the next year, you will earn interest on the amount net of tax, i.e., Rs.104.90, not Rs.107. While in the case of debt mutual funds, the compounding will happen on the entire gain amount. This can make a huge difference to the corpus you can accumulate through Bank FDs versus debt funds over a long-term horizon of 10+ years.

  1. Can be used for post-retirement income generation:

Despite this new tax rule, debt funds can be used for post-retirement income generation in a tax-effective way as compared to Bank FDs. These still fit well in the first as well as the second bucket of the bucketing strategy to plan post-retirement income generation. Let us take an example to understand this better. Also Read more: How to Manage Post Retirement Income flow – Bucketing strategy

Suppose, you are retired and have a corpus of Rs.1 crore with you. You require a monthly income of Rs.50,000 to meet your expenses. It means you would need an annual withdrawal of Rs. 6 Lakhs (for the sake of simplicity, let’s ignore inflation for now). 

You deposit this amount in a Bank FD @6% p.a., to get an annual interest income of Rs.6 lakhs. Assuming you belong to the 30% tax slab, you will have to pay Rs.1.80 lakhs (approx.) as tax on this interest income of Rs.6 Lakhs.

In contrast, let’s say you have invested this amount in a debt mutual fund at an NAV of Rs.100 and bought 10 lakh units. At the end of 1 year, let’s say, the NAV of the fund has increased to Rs.106 and the total value of your investment is now Rs.1.06 crores.

If you want to withdraw Rs.6 lakhs from the corpus, you need to redeem 5,660 units (6,00,000/106). The gain on these units would be Rs.33,960. [(106 – 100)* 5,660] ; and the tax you would have to pay on this gain @30% would be just Rs.10,188.

Also, it might be possible that post-retirement your taxable income might reduce and fall into the lower tax slabs. It might reduce the tax liability even further. It implies that, even under the new tax rules, debt funds are way more tax-efficient tools to generate income in comparison to fixed deposits.

  1. Ideal for short-term needs: 

The debt mutual fund taxation has not changed for short-term capital gains. So, if you want to park money for a short-term goal, due within 3 years, debt mutual fund categories like- liquid, ultra-short term, money market funds etc. have the potential to earn better returns than fixed deposits and of course, offer better flexibility too. But, do note that these funds have their own share of risks too. Also Read more: Type of Debt Funds – Know well to select good

  1. Setting-off Short-term capital losses:

This is another advantage of debt mutual funds. You can set-off short-term capital losses on your investments including equity, debt, gold, or real estate using the gains realized on debt funds.

Bottom Line: 

Tax rules keep changing every few years. It is a reality. 

The new tax rules have snatched away the favorable tax treatment of debt funds, one of the biggest merits over Bank FD. With the taxation being the same now, you might think- why to take risk with debt mutual funds? With FDs, at least the capital would be safe.

With these new debt mutual fund taxation rules in place, some endowment plans like HDFC Sanchay Plus, that offer tax-free guaranteed returns. However, do remember, these insurance cum investment plans have their own disadvantages- lock-ins, illiquidity, high costs, etc. And nowadays, if invested above Rs 5 lakh, the tax free interest advantage has gone in Insurance too. Read more: HDFC Life Sanchay Plus Review – Guarantee has its Minus too

With that said, your investment strategy should not change only on the basis of the tax rules. Barring the tax advantage, there are various other benefits that debt funds offer, as mentioned above.

Also, if we look at it from another perspective, debt, international and gold funds provide much needed diversification to your investment portfolio thereby optimizing the overall portfolio returns, across market cycles. Also Read more: International Mutual Funds in India- Should you Invest?

Yes, tax does play an important role but we cannot do much about the changing of tax rules. We have to live with these.

So, in my opinion, you should continue investing in debt mutual funds. Yes, one thing you might do is- you can open a separate folio for the investments post 1st April, 2023. This will segregate the fund on which indexation is allowed and disallowed. When you need to redeem the funds, you can check which one has lower tax incidence and take action accordingly.


  1. Detailed comparison of pros and cons of FDs vs Debt MFs in view of new taxation rules. For lower bracket income personc, the Debt MFs are still beneficial.
    That is what I could conclude.
    Thanks for educating on this subject. 🙏


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