Debt funds, an investment vehicle, pool funds for diverse debt securities like bonds, debentures, notes, or certificates of deposit. They aim to offer regular income through interest and capital gains.
Investors favor debt funds for steady income, diversification, and liquidity. Yet, there are tax implications, especially in South Africa.
Explore how debt funds are taxed, calculate tax on them, understand tax advantages, grasp dividend taxation on debt funds, and discern why they might be preferable to equity in this article
How are Debt Funds Taxed?
Debt funds undergo varied taxation based on income type and source. Broadly, they generate interest income and capital gains.
Interest income results from lending or issuing bonds, subject to income tax at the investor’s marginal rate (18% to 45%). Individual rates range based on taxable income (18% to 45%), while trusts face rates from 36% to 45%.
Capital gains, profits from selling securities, face capital gains tax (CGT) at 18% or 36%. The source matters; endowment policy-related gains fall under CGT. An endowment policy, a life insurance type, accumulates value and pays a lump sum upon death or maturity.
How Do You Calculate Tax on Debt Funds?
To calculate tax on debt funds, gather:
- Investment amount
- Interest payments received
- Capital gains received
- Type and source of income
- Investor’s taxable income bracket
Use these formulas:
Tax on Interest Income = Interest Income × Tax Rate
Capital Gains Tax = Capital Gains × Tax Rate
Net Return after Tax = Investment Amount + Interest Payments – Capital Gains – Tax
For example, if a guy sets aside R100,000 for a debt fund with an 8 percent interest rate, gets R8,000 interest after one year, and trades it for R120,000 at a profit, entering the highest tax class:
Interest Income Tax = R8,000 × (45% + 18%) = R16,400
Capital Gains Tax = R12,000 × (36% + 18%) = R30,600
Net Return following a Tax = R100,000 + R8,000 – R12,000 – R46,800 = R21,200
Hence, the tax liability stands at R46,800, while the post-tax return stands at R21,200.
What Is The Tax Advantage of Debt Funds?
Investing in debt funds has its perks over diving into equity funds. One major plus is their lower risk and decreased volatility compared to their stock counterparts. Debt funds primarily channel funds into fixed-income securities, ensuring regular interest payouts and less rollercoaster-like price swings than what you’d find in the stock market. It’s a solid choice for those keen on safeguarding their capital and enjoying consistent returns.
Yet another feather in the cap for debt funds is their superior liquidity compared to equity funds. Liquidity, denoting how smoothly an asset transforms into cash without upsetting its value, is a strong suit here. Redeeming debt funds happens seamlessly at any time, sans penalties or value loss, a stark contrast to stocks that might come with brokerage fees or capital gains taxes upon sale.
And let’s not forget the third jewel in the crown – debt funds outshine equity funds in the realm of diversification. Diversification, the art of spreading your investments across varied asset classes, sectors, countries, and more, takes the lead in risk reduction and return enhancement. Debt funds ace this game by branching into different fixed-income securities, varying in maturities, credit ratings, and interest rates. The result? A shiled against market peaks and valleys.
How Dividend is Taxed on Debt Fund?
Dividends are that delightful chunk of profit companies and mutual funds shared with their shareholders or unitholders. Regarding the dividend case with debt funds, here’s a positive note: under section 10(34A) of the Income Tax Act, the dividend showered upon investors is typically tax-free.
But hold on, this tax tango has a couple of nuances. A special tax twist awaits if you’re receiving dividends from debt funds through an individual retirement annuity (IRA) scheme. Depending on whether your debt fund resides in a taxable or a non-taxable account, you might encounter a 15% or 5% dividend distribution tax (DDT). Fear not, though – an IRA scheme is like a tax-saving superhero, allowing you to defer taxes on contributions and earnings until the glorious withdrawal day.
Now, let’s globe-trot a bit. If your debt funds venture into foreign debt securities territory, a withholding tax awaits them in the source country. Unless a tax treaty steps in with a benevolent lower rate or an outright exemption, your dividend from US bonds might face a 15% withholding tax in the US. Imagine a tax treaty between South Africa and the US riding to the rescue, reducing or eliminating that withholding tax.
However, here’s the golden rule – the tax treatment of your dividend from debt funds hinges on it being a product of income derived from debt securities, not some other source like capital gains or a return of capital. Stray from this rule; your dividend might be in the ordinary income tax arena, getting taxed at the investor’s marginal tax rate.
Essentially, the dividend journey with debt funds is like a tax-free stroll for most investors. However, watch for exceptions – the IRA scheme twist, the foreign source detour, or any unexpected non-debt sources. Before claiming exemptions or deductions, savvy investors would do well to scrutinize the nature and source of their dividends.
Why Debt Funds Are Better than Equity?
Debt funds form a wise option for an investor who wants to safeguard his money and with some regular income without taking much risk. The investment in this form of fund is completed in fixed-income securities, offering a standard interest, and does not shift too much in value. However, the outstanding feature about them is that they are manageable, and you can regain your cash anytime without any waste. It also spreads its money on different types of fixed-income securities from different sectors and regions. So, if you want to keep your money safe, get regular income, and lower your risk, debt funds could be perfect for you.
