InvestorQ : What is more tax efficient for an investor - bonds or bond funds?
Dawn Cherian made post

What is more tax efficient for an investor - bonds or bond funds?

Juvina Maggie answered.
3 years ago

Debt funds are fairly tax efficient when compared to other debt products. For example, interest earned on bank FDs and corporate FDs are fully taxable at the peak rate applicable to you. If your returns on debt funds are structured as dividends then you do not have to pay any tax on your dividend income although the fund does deduct the DDT at 29.12%. However, if you structure your debt fund as a growth plan and hold it for more than 3 years then it is classified as long term capital gains. In this case the entire return earned over 3 years is taxed at just 20% after considering the indexation benefits. The effective rate of tax comes to below 10% when indexation is considered and that makes debt funds substantially more tax efficient than FDs. You can also structure withdrawals in the form of SWPs. In the case of SWP, you draw down your corpus systematically over time and just pay capital gains tax on the profit component and not on the principal component. The moral of the story is that there is certainly value in adding debt to your portfolio. On the one hand, it makes your portfolio more stable and predictable. On the other hand, debt exposure via debt funds also makes your portfolio more tax efficient. That is why the inclusion of appropriate share of debt in your portfolio can actually reduce risk and enhance risk-adjusted returns.