Think Debt is a joint initiative between ICICI Prudential MF and Wealth Forum, which aims at sharing new thoughts and paradigms to help all of us make deeper inroads into the large pool of conservative retail savings.

Educating the retail saver on debt funds is the best way to make a beginning in this direction. And that is exactly what Team ICICI Prudential MF has done with this 4 part education series, which offers a beginners guide to debt funds in a simple Q&A format. Do share this article series with all your clients and prospects, and help build their conviction in debt funds as an integral part of their investment portfolios.

What kind of returns do Debt Funds offer?

Debt funds offer two kinds of income:

1. Dividends &

2. Capital gains

Dividends: Debt funds receive interest on the debt securities invested by the fund. This interest can be distributed to the investors of the debt fund as dividends. Dividend distribution is however subject to availability of distributable surplus and approval from the Trustees of the Mutual Fund.

Capital gains: As stated earlier, debt fund managers trade in debt securities in the debt segment in order to earn profits. This gain or loss is typically reflected in the NAV movement of the debt scheme which would include the accrued interest on the securities too. For instance, let's say an investor invests in a debt scheme at an NAV of say, Rs 12; when he wants to redeem, if the NAV is say, Rs 13.5, he would earn a capital gain of Rs 1.5 per unit (Rs 13.5 minus Rs 12).

What about tax? Do I need to pay tax on my debt mutual funds?

Tax on dividend income:

Dividend income that you receive from your debt fund is tax-free in your hands. However, the mutual fund has to pay tax (called Dividend Distribution Tax) at the rate of 28.84% for individuals before distributing dividend. In other words, you get dividend after payment of this tax.

Tax on capital gains:

Tax on capital gains in case of debt funds depends on how long you stay invested in the fund for. If you stay invested for less than 3 years, the capital gain gets added to your other income and is taxed according to rate applicable to your total income. For instance, if you are in the tax bracket of 20% and you earn a capital gain of Rs 5,000 on redemption of your debt scheme, you will pay tax of Rs 1,000 (20% of Rs 5,000).

If you stay invested for more than 3 years, the capital gains that you earn from your debt funds are taxed at a lower rate of 10% without indexation or 20% with indexation (the government publishes a cost inflation index table each year for this purpose), whichever is lower. Indexation helps you increase the cost of your investment to account for inflation. So for example, if you have invested in a debt scheme at Rs 10 and redeemed after 3 years at Rs 20, you either pay 10% tax on Rs 10 (Rs 20 minus Rs 10) or 20% tax on Rs 7.40 (Rs 20 minus Rs 12.60 - assuming inflation @8% over 3 years¹). You pay tax on the lower of the two, that is, 10% of Rs 10, which is Re 1 or 20% of Rs 7.40, which is Rs 1.48. So you pay Re 1 per unit as tax.

My bank deposits offer me the 'cumulative' facility where my interest is reinvested and given to me along with my deposit amount when the deposit matures. Do mutual funds offer something similar?

Mutual funds offer three ways of receiving income:

1. Dividend payout: Here, you instruct the mutual fund to pay you the dividends when they are declared. In other words, the dividend amount is credited to your bank account.

2. Dividend reinvestment: Here, you instruct the mutual fund to reinvest the dividend due to you back into the scheme. In this case, the reinvestment into the scheme is done at the NAV at the time of the dividend declaration.

3. Growth: Here, you instruct the mutual fund not to give you the dividend; instead, the dividend is retained within the scheme and the NAV of the scheme accordingly rises. Hence, instead of dividend, you get capital appreciation. This option is similar to the 'cumulative' option offered in bank deposits.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

This article should not be considered as 'investment advice'. We request the Reader to make informed investment decisions and consult their financial advisors to determine the financial implications with respect to investing in Mutual Funds.

¹ Please note: The inflation rate has been assumed and calculations have been done accordingly. Please also seek assistance from your tax advisor.

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