Investors often do not think about tax consequences when making investment decisions. For example, a downside of investing in fixed deposits is interest income that is added to your taxable income and is fully taxable as per the income tax slab rate, which is disadvantageous for investors who are in the highest income tax bracket. Your return on investment has a negative impact due to the tax obligations, making it challenging to earn inflation-beating returns.
On the other hand, mutual funds are the most buzzing investment options as they help you achieve your financial goals by building a corpus in a gradual but consistent manner and are one of the most tax-efficient investment options available in the market. A mutual fund investment offers you the advantages of professional money management and tax-efficient returns. An important thing to keep in mind while investing in mutual funds is that tax incidents only occur when units in a mutual fund scheme are sold.
Mutual Funds are also taxed like other investments by the government; however, they are subject to different tax treatments depending on the category of the scheme. The SEBI (Securities and Exchange Board of India) lays down the taxation rules. However, there are different tax regulations for dividends and capital gains as well as equity and debt funds. According to their asset allocation and SEBI regulations, some funds, such as hybrid funds or dynamic asset allocation funds, are also taxed as either equity or debt. For both equity and debt funds, there are different regulations for long and short-term investments. Let’s discuss in detail the taxation and tax exemption of Mutual Funds.
This article discusses the different tax implications of various types of mutual funds, helping you select the best suitable mutual fund schemes.
Before we discuss the taxation rules for mutual funds, it is important to know that returns earned from mutual funds fall under two heads dividend 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 earn dividends in proportion to the number of units they own in mutual funds.
When the scheme units are redeemed, the total fund value, including the invested value and the returns on it, counts for the capital gains of the investor. The increase in the price of mutual fund units results in capital gains. Both dividends and capital gains are taxable in the hands of investors of mutual funds.
Given that the tax implications can have a significant impact on the returns earned, it is necessary to understand the tax implications for both these heads of income, i.e., dividend and capital gains.
Tax on dividend income from Mutual Funds
Apart from capital appreciation, another way you can earn returns from Mutual Funds is through dividends. If you choose a mutual fund’s dividend plan, the fund will split its gains with you. Dividends are usually taxable income. When you make an investment in a mutual fund, you often have the option of choosing to receive your portion of dividend payments directly or to have them automatically reinvested in the fund.
In April 2021, the’ Dividend’ nomenclature was changed by the Securities and Exchange Board Of India (SEBI). What used to be called ‘Dividend’ earlier is now called ‘distribution’. And the ‘Dividend Plan’ of a mutual fund scheme is now called the ‘Income Distribution cum Capital Withdrawal Plan’ or IDCW Plans. In addition, SEBI has also changed the names of dividend reinvestment options and dividend transfer plans, i.e., reinvestment of income distribution and transfer of income distribution and capital withdrawal.
The taxation for IDCW Plans in mutual funds has also changed. Until the Union Budget 2020-21, dividends declared by mutual funds were subject to DDT or dividend distribution tax, where the fund house deducts the tax on your behalf and transfers the dividend net of tax to you. Even though the amount was not directly taxed in your hands, you still felt the effects because the DDT payout would lower the NAV.
However, post the amendments announced in the Union Budget 2020-21, the dividends from both equity and debt mutual funds are now taxable in the hands of the investor or unitholder according to the investor’s tax bracket. Consequently, Investors in the 30% tax bracket will have to pay 30% tax on the dividends received.
Tax on Capital gains from Mutual Funds
The taxation rate of capital gains of mutual funds depends on the holding period and type of mutual fund. The period of investment in a mutual fund scheme is known as the holding period of the plan. The holding period plays a crucial role in determining the tax implications of your mutual fund investments.
The holding period is categorised as:
- Long-term Investments Equity-oriented mutual funds that have a holding period of 12 months or more are considered as long-term investments. When it comes to debt funds, investments with a holding period of 36 months or more are considered as long-term investments.
- Short-term Investments Equity mutual fund schemes that are held for less than 12 months are categorised as short-term investments. If the holding period for debt funds is less than 36 months, the investment is regarded as short-term.
Capital gains realised on selling units of mutual funds are categorised as follows:
Type of Mutual Funds | Short-term Capital Gains | Long-term Capital Gains |
Equity Funds | Less than 12 months | 12 months and above |
Hybrid equity-oriented funds | ||
Debt Funds | Less than 36 months | 36 months and above |
Hybrid debt-oriented funds |
Taxation on Equity-oriented Funds
Mutual funds that allocate at least 65% of their funds in equities (stocks) are termed as equity-oriented funds. As previously stated, when you redeem your equity fund units during a holding period of one year, you realise short-term capital gains. Regardless of your income tax status, these gains are taxed at a flat rate of 15%.
When you sell your equity fund units after holding them for at least a year, you will receive long-term gains. This LTCG, up to Rs. 1 lac from equity-oriented mutual funds, are tax-free. Any long-term capital gains that surpass this threshold are subject to LTCG tax at a rate of 10%, with no benefit of indexation.
Taxation on Debt-oriented Funds
Mutual funds that invest in fixed-income instruments like government and corporate bonds, money market instruments, and corporate debt securities are known as debt-oriented mutual funds. Debt funds are those mutual funds whose portfolio’s debt exposure is in excess of 65%. As shown in the table above, if you redeem your debt fund units during the first 3 years of holding them, you will receive short-term capital gains. These gains are included in your taxable income and taxed at the rate specified by your tax bracket.
When you sell units of a debt fund after 3 years of owning them, you realise long-term capital gains. These LTCG’s are taxed at a flat rate of 20% after indexation.
Taxation on Hybrid Funds
The rate of taxation of capital gains on hybrid or balanced funds is dependent on the equity exposure of the portfolio. The mutual fund scheme is taxed like an equity fund if the equity exposure exceeds 65 %; otherwise, the debt fund taxation rules are in effect.
Type of Mutual Funds | Short-term Capital Gains | Long-term Capital Gains |
Equity Funds | 15% | Tax-exempt up to Rs 1 lac. Above Rs 1 lac LTCG tax at the rate of 10% without indexation. |
Hybrid equity-oriented funds | ||
Debt Funds | Taxed as per investor's income tax slab rate | 20% with indexation |
Hybrid debt-oriented funds |
To take advantage of rupee cost averaging and the power of compounding, many investors prefer investing in mutual funds through Systematic Investment Plans (SIPs). SIPs provide the convenience for investors to invest a small sum in a mutual fund scheme regularly. Investors have the option of selecting the frequency of their investments, weekly, monthly, quarterly, etc.
Mutual funds SIPs allow investors to instil financial discipline and regularly invest in a systematic manner. However, compared to traditional lump sum investment, capital gains taxation when made through SIPs in mutual funds is different.
Taxation on Gains from SIPs in Mutual Funds
The taxation of SIPs depends on the frequency of investment. The gains from each SIP investment are taxed differently and are classified as independent investments. With each SIP instalment, you buy a set amount of mutual fund units. These redemptions are handled on a first-in, first-out basis. Consider making a one-year SIP investment in an equity fund, and you decide to redeem your entire investment after 13 months.
When long-term capital gains are realised on the first units purchased through the SIP, and they are kept for a long period of time (more than a year), LTCG tax at the rate of 10% is applicable. Your tax is exempt if your total long-term capital gain is less than Rs 1 lac in a financial year.
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. For instance, Mr A invests Rs. 10,000 per month via SIP mode in an equity-oriented mutual fund for 12 months. At the end of twelve months, the investor decides to redeem the entire corpus of the investments as well as the gains made.
In this case, not all the gains are tax-free. Only the profits made from the first SIP investment are tax-free since the holding period is one year. All other gains are subject to STCG (short-term capital gains) tax as they pertain to a holding of less than 12 months.
To conclude…
Everyone wants to save on tax. But not many are aware of the best investing avenues and techniques to lower tax obligations. Now that you know all about Mutual Funds taxation, you can minimise the taxes you need to pay on your returns with some effective planning.
When it comes to maximising the tax benefits of your mutual fund investments, the longer you hold on to it, the more tax-efficient they become. The tax levied on long-term capital gains is significantly lower than that on short-term capital gains.
Therefore, ensure to be aware of the various tax implications to get the most benefits from your mutual fund investments. Additionally, you must invest in worthy mutual funds as per your suitability based on your risk profile, investment horizon and objectives to build a wealthy corpus and robust investment portfolio.
This article first appeared on PersonalFN here