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Mutual Fund Taxation – How mutual funds are taxed?

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The primary aim of any investor is capital appreciation. Investing in mutual funds generates capital gains, which is taxable. The article discusses how mutual funds are taxed depending on their type.

1. Mutual Funds Holding Period and Taxation

The primary purpose of investing is wealth maximization in the form of interest, dividends, or capital gains. The period during which an investor stays invested (or) the duration for which the investor holds his investment is known as holding period. The holding period is required to determine the tax implications your investment carries.

2. Types of Holding Periods

a. Long-Term Holding Period

In the case of equity mutual funds, a holding period of 12 months or more is regarded as long-term. However, in the case of debt funds, the investment is considered long-term if the holding period is 36 months or more. So, the tax will help determine the capital gain (or) loss on the investment.

b. Short-Term Holding Period

Equities are short-term investments if the holding period is less than 12 months. In the same line, debts funds are viewed as short-term if the holding period is less than 36 months. Hence, short-term capital gains taxes apply to any income generated from securities held for less than 36 months or three years. Some examples of short-term securities include treasury bill, 91-day bonds, etc.

The following table gives a glimpse of the holding period classification of mutual funds:

Funds

Short-term

Long-term

Equity funds

Less than 12 months

12 months and more

Balanced funds (equity-oriented)

Less than 12 months

12 months and more

Balanced funds (debt-oriented)

Less than 36 months

36 months and more

Debt funds

Less than 36 months

36 months and more

Balanced funds attract equity tax only if it has more than 65% of equity exposure. If the equity exposure is less than 65% or is equally exposed to equity and debt instruments i.e., 50% equity and 50% debt, it will still fall under Debt taxation.

3. Taxation on Mutual Funds

a. Tax-Saving Equity Funds

ELSS is the most tax-efficient tax-saving instrument under Sec 80C falling under the provisions of the Income Tax Act, 1961. These funds invest in equity & equity-related securities.

Tax-Saving ELSS schemes are Closed-ended funds with a lock-in period of 3 years. At the time of redemption, if your investment amount is more than 1L then LTCG will be applicable at 10% without indexation. If the amount is less than or equal to 1L, then you are not liable to incur tax.
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b. Non-Tax Saving Equity Funds

Long-term capital gains (LTCG) on non-tax saving equity funds up to Rs 1 lakh is free of taxation. LTCG above Rs 1 lakh is taxable at the rate of 10% without the benefit of indexation.
Example:

Mr A purchased shares worth Rs 100 on 30th September 2018 and sold them on 31 December 2019 at Rs 120. The Value of the Stock was Rs 110 as on 31 January 2019. Out of the capital gains of Rs 20 (i.e. 120-100), Rs 10 (i.e. 110-100) is not taxable. Rest Rs 10 is taxable as Capital gains @ 10% without indexation.

Furthermore, there is a 15% tax (surcharge and cess as applicable) on short-term gains from equity funds (Where STT is applicable) upon redemption of units before the completion 12 months.

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c. Debt Funds

Long-term capital gains on debt fund are taxable at the rate of 20% after indexation. Indexation is a method which involves factoring the rise in inflation from the time of purchase to sale of the units.

Indexation allows inflating the purchase price of debt funds to bring down the quantum of capital gains. You are required to add short-term gains from debt funds to your overall income. They are subject to short-term capital gains tax (SCGT) as per the income tax slab you fall under.

d. Balanced funds

Balanced funds are equity-oriented hybrid funds that invest at least 65% of their assets towards equities. The tax treatment on balanced funds is precisely the same as non-tax saving equity funds.

Balanced funds

e. SIPs

A SIP or a systematic investment plan is offered by AMCs to investors to park a small amount of money in various mutual funds across fund houses. Investors can invest a fixed amount on a daily, weekly, fortnightly, monthly, or quarterly. As detailed above, gains from SIPs are taxable as per the type of mutual fund you invest in and its holding period. Each SIP, treated as a new investment, attracts taxes on its gains separately.

For instance, you begin a SIP of Rs10,000 a month in an equity fund for 12 months. Each SIP is considered to be new investment. Hence, after 12 months, if you decide to redeem your entire accumulated corpus (investments plus gains), all your gains will not be tax-free. Only the gains earned on the first SIP would be tax-free because only that investment would have completed one year. The rest of the gains would be subject to short-term capital gains tax.

f. Securities Transaction Tax (STT)

Apart from these, there is another type of tax called the Securities Transaction Tax (STT). An STT of 0.001% is levied by the government (Ministry of Finance). when you decide to sell your units of an equity fund or balanced fund. There is no STT on the sale of debt fund units.

4. Conclusion

The longer you hold onto your mutual fund units, the more tax-efficient they become. The tax on long-term gains is comparatively lower than that of the tax on short-term gains.

Do you find the information taxing? Many do. That is why ClearTax has an LTCG tax filing and advisory service that you can make use of every financial year. You are just one click away from simplifying your taxes.