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.

Latest Update

• No indexation benefit will be available while calculating long-term capital gains on Debt Mutual Funds (i.e., mutual funds that invest less than 35% of their corpus in equities or equity-related instruments).
• Debt mutual funds will now be taxed as per the investor's applicable slab rates. Capital Gains arising from Debt Mutual Funds are always treated as Short Term Capital Gains.
• Only applicable for debt funds investments purchased after 1 April 2023.

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 realized by investors if the selling price of the security held by them is greater than the purchase price. In simple terms, capital gains are realized 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 categorized as follows:

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

Tax Rates for Short Term and Long Term Capital Gains

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.

Note: 

• The taxation of Short-Term Capital Gain for listed equity shares, a unit of an equity-oriented fund, and a unit of a business trust has been increased to 20% from 15%. Other financial and non-financial assets which are held for short term shall continue to attract the tax at slab rates.
• The limit on the exemption of Long-Term Capital Gains on the transfer of equity shares or equity-oriented units or units of Business Trust has increased from Rs.1 Lakh to Rs.1.25 lakh per year. However, the rate at which it is taxed has increased from 10% to 12.5%. 
• The tax rates of funds that are neither not aggressive equity fund not debt fund  (invest more than 35% but less than 65% in equity) is now taxable at 12.5% without indexation.
• The exemption limit to Rs. 1.25 lakhs has been increased for the whole of the year, whereas the tax rate has changed on 23rd July 2024.
• Indexation benefit is also not available after 23rd July 2024.

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 1.25 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 20% 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 0.1% 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.

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