An income fund is a type of debt mutual fund which generates returns by investing in relatively long-dated debt instruments like government securities, corporate bonds, debentures, certificates of deposit, etc. Two categories of mutual funds (as defined by SEBI) can broadly fall into this category As per SEBI classification of mutual funds, the following two debt funds are income funds:
- Medium to Long Duration Fund: It is an open-ended debt scheme which invests in debt and money market instruments such that the Macaulay Duration of the fund is between 4-7 years.
- Long Duration Fund: It is an open-ended debt scheme which invests in debt and money market instruments such that the Macaulay Duration of the fund is more than 7 years.
Benefits of Investing in Income Funds
- Higher returns than FDs: Income funds generally generate returns higher than fixed deposits in the long term. They aim to do so by taking advantage of interest rate volatility. However, income funds do carry interest rate risk and credit risk whereas FDs carry negligible or zero risk.
- High liquidity: Unlike some fixed deposits, income funds do not have any lock-in period and allow investors to anytime withdraw their investment. However exit loads may be imposed for redemptions in these funds from 1-3 years.
- Tax efficient: Income funds are tax efficient than fixed deposits, especially for those investors who fall in the income tax brackets of 30%. Long-term capital gains (holding period over 3 years) on debt funds are taxed at 20% with indexation unlike interest on fixed deposits which is taxed as per the investor’s income tax slab.
Who Should Invest in Income Funds?
Income funds are suitable for investors who have an investment time horizon of at least 4 years and are willing to take a moderate amount of risk.
Income Funds Taxation
Dividends and capital gains earned on mutual funds are taxed differently. Dividends are not taxable in case of debt funds after the investor receives them. However, a dividend distribution tax is payable directly by the fund house to the government before it reaches the investor and this is included in the expense ratio of the fund. With respect to capital gains tax, this is taxable in the hands of the investor.
Capital gains can be taxed as short term capital gains or long term capital gains depending on how long units of the debt fund were held prior to being redeemed or switched. Debt fund profits come under the purview of short term capital gains in case the fund’s units have been held for less than 3 years from the date of unit allotment before they were redeemed or switched to a different scheme. These short term gains are taxed according to the investor’s income tax slab. Such profits are included in the annual income of the investor under the income from other sources head in the ITR form.
Long term capital gains in case of debt funds occur in case units of the mutual fund have been held for over 3 years from the date of allotment prior to being switched/ redeemed. Long term capital gains for debt funds are taxed at 20% with indexation. You can find out more about this here.