Mutual Fund Taxation – How Mutual Funds Are Taxed?

Mutual funds are one of the most buzzing investment options as they help you achieve your financial goals. Mutual funds are also tax-efficient instruments. Investing in fixed deposits is a great disadvantage, particularly if you fall under the highest income tax bracket, as the interest is added to your taxable income and taxed at your income tax slab rate. This is where mutual funds score better. When you invest in a mutual fund, you get the benefit of expert money management and tax-efficient returns.

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What is Tax on Mutual Funds?

Profits gained from investment in mutual funds are known as ‘Capital gains’. These capital gains are subject to tax. So, before investing in mutual funds, you should clearly understand how your returns will be taxed. Moreover, you can also avail tax deductions in certain cases. 

What are the Factors to Determine Tax on Mutual Funds?

Taxation on mutual funds can be explained further by pointing out the factors influencing it. Here are the essential factors that affect the taxes levied on mutual funds:

• Fund types: Taxation rules differ based on the type of mutual fund. E.g.: Equity Mutual Fund, Debt Mutual Fund, Hybrid Mutual Fund etc.
• Dividend: A part of the profit distributed amongst investors by mutual fund houses is called dividend. 
• Capital gains: When investors sell their capital assets at a higher price than its total investment amount, the profit is termed as capital gains.
• Holding period: Time between the date of the purchase and sale of mutual fund units. As per the income tax regulations of India, if you hold your investment for an extended period, you will be liable to pay a low tax amount. Thus, the holding period influences the tax rate payable on your capital gains. The higher your holding period, the lesser tax you are liable to pay.

How Do You Earn Returns in Mutual Funds

Mutual funds offers returns in two forms: dividends and capital gains. Dividends are paid out of the profits of the company if any. When the companies are left with surplus cash, they may decide to share the same with investors in the form of dividends. Investors receive dividends proportional to the number of mutual fund units held by them.

A capital gain is the profit realised by investors if the selling price of the security held by them is greater than the purchase price. In simple terms, capital gains are realised due to the appreciation in the price of the mutual fund units. Both dividends and capital gains are taxable in the hands of investors of mutual funds.

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Taxation of Dividends Offered by Mutual Funds

As per the amendments made in the Union Budget 2020, dividends offered by any mutual fund scheme are taxed in the classical manner. That is, dividends received by investors are added to their taxable income and taxed at their respective income tax slab rates.

Previously, dividends were tax-free in the hands of investors as the companies paid dividend distribution tax (DDT) before paying dividends.

Taxation of Capital Gains Offered by Mutual Funds

The taxation rate of capital gains of mutual funds depends on the holding period and type of mutual fund. Capital gains realised on selling units of mutual funds are categorised as follows:

The short-term and long-term capital gains offered by mutual funds are taxed at different rates.

Taxation of Mutual Funds

Taxation of mutual funds depends on the holding period. However, if the debt mutual funds i.e. the mutual funds with investment less than 35% of its proceeds in the equity shares of a domestic companies will be considered as short-term irrespective of the holding period. It is to be noted that this is applicable only if the debt mutual funds are purchased after 31 March 2023. The following table will help you understand better.

Taxation of Capital Gains of Equity Funds

Equity funds are those mutual funds where more than 65% of it total fund amount is invested in equity shares of companies. As mentioned above, you realise short-term capital gains if you redeeming your equity fund units within a one year. These gains are taxed at a flat rate of 15%, irrespective of your income tax bracket.

You make long-term capital gains on selling your equity fund units after holding them for over one year. These capital gains of up to Rs 1 lakh a year are tax-exempt. Any long-term capital gains exceeding this limit attracts LTCG tax at 10%, without indexation benefit.

Taxation of Capital Gains of Debt Funds

Debt funds are those mutual funds whose portfolio’s debt exposure is in excess of 65% and equity exposure is not more than 35%. Starting 1st April 2023, the debt funds will no longer receive indexation benefit and deemed to be short-term capital gain. Therefore, the gains from debt funds will now be added to your taxable income and taxed at the slab rate.

Earlier, the long-term capital gains from debt funds were taxed at 20% with indexation benefit. 

Taxation of Capital Gains of Hybrid Fund

The rate of taxation of capital gains on hybrid or balanced funds is dependent on the equity exposure of the portfolio. If the equity exposure exceeds 65%, then the fund scheme is taxed like an equity fund, if not then the rules of taxation of debt funds apply.

Therefore, it is essential to know the equity exposure of the hybrid scheme you are investing in, if not then you might be in for a nasty surprise on redemption of your fund units. The following table summarises the rate of taxation of capital gains on mutual funds:

Taxation of Capital Gains When Invested Through SIPs

Systematic investment plans (SIPs) are a method of investing in mutual funds. They are designed in such a way that investors can invest a small amount periodically in a mutual fund scheme. Investors are offered the liberty to choose the frequency of their investment. It can be weekly, monthly, quarterly, bi-annually, or annually.

You purchase a certain number of mutual fund units through every SIP instalment. The redemption of these units is processed on a first-in-first-out basis. Suppose you invest in an equity fund through an SIP for one year, and you decide to redeem your entire investment after 13 months.

In this case, the units purchased first through the SIP are held for the long-term (over one year) and you realise long-term capital gains on these units. If the long-term capital gains are less than Rs 1 lakh, then you don’t have to pay any tax.

However, you make short-term capital gains on the units purchased through the SIPs from the second month onwards. These gains are taxed at a flat rate of 15% irrespective of your income tax slab. You will have to pay the applicable cess and surcharge on it.

Securities Transaction Tax (STT)

Apart from the tax on dividends and capital gains, there is another tax called the Securities Transaction Tax (STT). An STT of 0.001% is levied by the government (Ministry of Finance) when you decide to buy or sell mutual fund units of an equity fund or a hybrid equity-oriented fund. There is no STT on the sale of debt fund units.

Conclusion

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

Frequently Asked Questions

Are mutual fund taxes payable every year?

If you opt for a mutual fund scheme, you need to pay the applicable taxes only when you redeem the units or sell the scheme. It does not count on every year. However, your total income for the financial year in question includes your dividend income from mutual fund schemes. So, you need to pay tax for this dividend income if your income is liable to income tax.

Is it possible to avoid capital gains tax?

No, you cannot avoid paying tax on capital gains; instead, you can plan your investment accordingly to be tax efficient. For instance, taxes applicable on short-term capital gains are higher than the long-term ones. So, you need to understand the types of taxes levied on mutual fund schemes.

What are the factors to keep in mind before choosing tax-saving mutual funds?

Though tax-saving mutual funds have certain limitations, you should consider four factors while picking one. They are mode of investment, asset allocation, tax-exemption limits and lock-in period.

Can mutual fund investments help me get a rebate on income tax?

Under Section 80C of the Income Tax Act, tax benefits are applicable in the case of ELSS or Equity Linked Saving Schemes. You can get up to Rs.1.5 lakh in tax deduction and save around Rs.46,800 each year on taxes. One should remember that ELSS has a minimum lock-in period of three years. 

Are wealth taxes applicable to MF investments?

According to the Wealth Tax Act, mutual funds and other financial assets are exempted from any wealth taxes. So, you need not to pay wealth tax upon investing in a mutual fund.

What is Section 54EA regarding capital gains tax exemptions?

As per Section 54EA, a long-term capital asset that has been transferred before 1 April 2000 is invested in particular bond shares within six months of the transfer date, then there is an exemption from capital gains as computed under Section 54F. 

What are tax saving mutual funds?

ELSS are popularly known as tax saving mutual funds that can help you get deduction u/s 80C of the Income Tax Act.

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