Mutual Fund Taxation – How Mutual Funds Are Taxed?

Mutual funds are a popular investment option for those looking to grow their wealth and achieve financial goals. Beyond professional fund management and diversification, they also offer tax-efficient returns. Understanding how mutual funds are taxed can help you make smarter investment decisions and optimize your earnings.

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• Capital gains from debt mutual funds purchased on or after 1 April 2023 are always treated as short-term. 
• No indexation benefit is available on such debt mutual fund investments. 
• The gains are taxed at your applicable income-tax slab rate.

What is Tax on Mutual Funds?

When you invest in mutual funds, the profits you earn upon redemption are called capital gains. These gains are taxable, and the rate of tax depends on two main factors: the type of mutual fund (equity or debt) and how long you stay invested (the holding period). 

Equity funds and debt funds are taxed differently under short-term and long-term capital gains rules. Additionally, certain mutual funds, such as Equity Linked Savings Schemes (ELSS), offer tax deductions under Section 80C of the Income Tax Act. 

Understanding these tax implications helps you plan your investments more efficiently and maximize your post-tax returns.

What Factors Determine the Tax on Mutual Funds?

The taxation of mutual funds depends on several key factors. 

Fund Type

Taxation rules vary depending on the category of mutual fund, such as equity, debt, or hybrid funds. Each type is treated differently under the income tax laws.

Dividend

A dividend is the portion of a fund’s profits distributed to its investors. While dividends were once tax-free in investors’ hands, they are now added to the investor’s income and taxed according to the applicable income tax slabs.

Capital Gains

When you sell mutual fund units for more than what you invested, the profit earned is known as capital gains. These gains are classified as short-term or long-term based on how long you’ve held the investment.

Holding Period

The holding period, the time between purchasing and selling mutual fund units, plays a key role in determining tax liability. Generally, longer holding periods qualify for lower tax rates, encouraging long-term investing.

How Do You Earn Returns from Mutual Funds?

Mutual funds offer returns in two forms: dividends, and capital gains.  

Dividends

These are payments made to investors from the income earned by the mutual fund, such as dividends from the stocks or interest from bonds in the fund’s portfolio. 

Investors receive dividends in proportion to the number of mutual fund units they hold. Not all funds pay dividends, as some are growth-oriented, where returns accumulate within the fund.

Capital Gains

Capital gains are the profits you earn when mutual fund units are sold at a price higher than their purchase cost. For mutual funds, these gains are only realized upon redemption of the units. 

As a result, the tax on capital gains is payable at the time of redemption and must be reported when filing your income tax return for that fiscal year.

Taxation of Dividends Offered by Mutual Funds

Under previous tax laws, the fund houses paid the Dividend Distribution Tax(DDT) on behalf of the investors. However, DDT was abolished and dividends offered by any mutual fund scheme are now taxable.

Under Section 194K, mutual funds are required to deduct TDS on dividend payments that exceed Rs. 10,000 per unitholder.

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) allow investors to invest a fixed amount regularly in mutual funds. Investors can choose the frequency of their contributions, such as weekly, monthly, quarterly, bi-annually, or annually.

When you invest in mutual funds through a Systematic Investment Plan (SIP), you purchase a set number of units with each instalment. The units are redeemed on a first-in-first-out (FIFO) basis. 

For example, if you invest in an equity fund through SIPs for one year and redeem your investment after 13 months:

• Units purchased first (during the first few months) are held for the long term (over one year) and are subject to long-term capital gains (LTCG) tax. If the LTCG is less than ₹1.25 lakh, no tax is payable.
• Units purchased later (within the last 12 months) are treated as short-term, and the short-term capital gains (STCG) are taxed at 15% (or 20% in some cases) with the applicable cess and surcharge.

Securities Transaction Tax (STT)

In addition to taxes on dividends and capital gains, there is also a tax called Securities Transaction Tax (STT). The government (Ministry of Finance) levies an STT of 0.1% on the purchase and sale of mutual fund units in equity funds or hybrid equity-oriented funds (those investing at least 65% in equities). However, STT is not applicable on the sale of debt fund units.

Final Word

The longer you hold your mutual fund units, the more tax-efficient your investment becomes. Long-term capital gains are taxed at a lower rate compared to short-term gains, making it advantageous to plan for the long term. By understanding how dividends and capital gains are taxed, you can make smarter investment decisions and maximize your post-tax returns.

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