Mutual Fund Taxation – How mutual funds are taxed?

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Mutual funds are one of the most buzzing investment options among as they help you achieve your goals. Mutual funds are also tax-friendly. As you might know, investing in fixed deposits is a great disadvantage, particularly if you fall under the highest tax bracket, as the returns are added to your overall income and taxed at your slab rate. This is where mutual funds score better. When you invest in a mutual fund, you get the benefit of expert money management. We have covered the following in this article:

1. How Do You Earn Returns in Mutual Funds?

Mutual funds offer investors with returns in two forms; dividends and capital gains. Dividends are profits shared by companies when they are thriving. 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 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 fund units in mutual funds. Both dividends and capital gains are taxable in the hands of investors.

2. Taxation of Dividends Offered by Mutual Funds

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

Previously, dividends were made tax-free in the hands of investors as the companies paid dividends distribution tax (DDT) before sharing their profits with investors in the form of dividends. During this regime, dividends (received from domestic companies) of up to Rs 10 lakh a year were made tax-free in the hands of investors. Any dividends in excess of Rs 10 lakh attracted dividends tax at 10%.

3. Taxation of Capital Gains Offered by Mutual Funds

The rate of taxation of capital gains provided by mutual funds depends on the holding period and type of mutual fund. The holding period is the duration for which the fund units were held by an investor. In simple words, the holding period is the timeframe between the date of the purchase and sale of fund units. Capital gains realised on selling units of mutual funds are categorised as follows:

 

Fund type

Short-term capital gains

Long-term capital gains

Equity funds

Shorter than 12 months

12 months and longer

Debt funds

Shorter than 36 months

36 months and longer

Hybrid equity-oriented funds

Shorter than 12 months

12 months and longer

Hybrid debt-oriented funds

Shorter than 36 months

36 months and longer

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

4. Taxation of Capital Gains of Equity Funds

Equity funds are those funds whose portfolio’s equity exposure exceeds 65%. As mentioned above, you realise short-term capital gains on redeeming your equity fund units within a holding period of one year. These gains are taxed at a flat rate of 15%, irrespective of your income tax slab rate.

You make long-term capital gains on selling your equity fund units after a holding period of one year. These gains of up to Rs 1 lakh a year are made tax-exempt. Any long-term capital gains exceeding this limit attract a tax at the rate of 10%, and there is no benefit of indexation provided.

5. Taxation of Capital Gains of Debt Funds

Debt funds are those funds whose portfolio’s debt exposure is in excess of 65%. As mentioned in the table above, you get short-term capital gains on redeeming your debt fund units within a holding period of three years. These gains are added to your overall income and taxed at your income tax slab rate.

Long-term capital gains are realised when you sell units of a debt fund after a holding period of three years. These gains are taxed at a flat rate of 20% after indexation. Read more about indexation here. Also, you are levied with applicable cess and surcharge on tax.

6. Taxation of Capital Gains of Hybrid Funds

The rate of taxation of capital gains offered by 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 scheme you are investing in, if not then you might be in for an unpleasant surprise upon redemption of your fund units. The following table summarises the rate of taxation of capital gains offered by mutual funds:

 

Fund type

Short-term capital gains

Long-term capital gains

Equity funds

15% + cess + surcharge

Up to Rs 1 lakh a year is tax-exempt. Any gains above Rs 1 lakh are taxed at 10% + cess + surcharge

Debt funds

Taxed at the investor’s income tax slab rate

20% + cess + surcharge

Hybrid equity-oriented funds

15% + cess + surcharge

Up to Rs 1 lakh a year is tax-exempt. Any gains above Rs 1 lakh are taxed at 10% + cess + surcharge

Hybrid debt-oriented funds

Taxed at the investor’s income tax slab rate

20% + cess + surcharge

7. Taxation of Capital Gains When Invested Through SIPs

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

You purchase a certain number of fund units through every SIP you invest. The redemption of these units is processed on a first-in-first-out basis. Consider investing in an equity fund through an SIP for one year, and you decide to redeem all your investment after 13 months. In this case, the first units purchased through the first SIP are held for a long-term 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 tax slab. You will have to pay the applicable cess and surcharge on it.

8. 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 your 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 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.