Filing for AY 2024-25 is coming soon
Keep calm and sign up for early access to our super filing platform

Mutual Fund Taxation: Understanding How Mutual Funds Are Taxed

Investing in mutual funds is a popular choice for individuals looking to achieve their financial goals. Not only do mutual funds provide expert money management, but they are also tax-efficient instruments. In this article, we will delve into the intricacies of mutual fund taxation and understand how your returns are taxed.

Factors Influencing Tax on Mutual Funds

Before investing in mutual funds, it is crucial to understand the factors that determine the taxation on your returns. Here are the key elements that impact the taxes levied on mutual funds:

1. Fund Types

Taxation rules differ based on the type of mutual fund. The three main categories are:

  • Equity Mutual Funds: These funds invest a significant portion of their assets in stocks.
  • Debt Mutual Funds: These funds primarily invest in fixed-income securities like bonds and government securities.
  • Hybrid Mutual Funds: These funds have a combination of both equity and debt instruments.

Each fund type has its own taxation rules, which we will explore further in this article.

2. Dividend

Dividends are a portion of the profits distributed among investors by mutual fund houses. It is important to note that dividends received from mutual funds are taxable in the hands of the investors. The taxation of dividends is determined by the investor's income tax slab rate.

3. Capital Gains

Capital gains are the profits realized by investors when they sell their mutual fund units at a higher price than the initial investment amount. Capital gains can be categorized as:

  • Short-term capital gains: If the holding period is less than 12 months.
  • Long-term capital gains: If the holding period is 12 months or longer.

The tax rates for short-term and long-term capital gains differ based on the type of mutual fund, which we will discuss in detail later.

4. Holding Period

The holding period refers to the time between the date of purchase and sale of mutual fund units. The income tax regulations in India consider the holding period when determining the tax rate payable on capital gains. Generally, a longer holding period results in a lower tax liability. It is important to note that the holding period varies for different types of mutual funds.

Returns in Mutual Funds: Dividends and Capital Gains

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

Dividends

Dividends are paid out of the profits generated by the mutual fund scheme. When the mutual fund company has surplus cash, they distribute a portion of it as dividends to the investors. The dividend received by investors is proportional to the number of mutual fund units held by them. However, it is essential to remember that dividends received from mutual funds are taxable in the hands of the investors.

Capital Gains

Capital gains are the profits realized when investors sell their mutual fund units at a higher price than the purchase price. This appreciation in the price of the mutual fund units results in capital gains. It is crucial to note that both dividends and capital gains from mutual funds are taxable.

Taxation of Dividends Offered by Mutual Funds

As per the amendments made in the Union Budget 2020, dividends offered by mutual fund schemes are taxed in a classical manner. This means that 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 distributing dividends.

Taxation of Capital Gains Offered by Mutual Funds

The taxation of capital gains on mutual funds depends on the holding period and the type of mutual fund. Let's explore the tax rates for different types of mutual funds:

Equity Funds

Equity funds are mutual funds where more than 65% of the total fund amount is invested in equity shares of companies. For equity funds, the tax rates for short-term and long-term capital gains are as follows:

  • Short-term capital gains (holding period less than 12 months): Taxed at a flat rate of 15%.
  • Long-term capital gains (holding period 12 months or longer): Long-term capital gains up to Rs 1 lakh per year are tax-exempt. Any gains exceeding this limit are taxed at 10% without indexation benefit.

Debt Funds

Debt funds primarily invest in fixed-income securities like bonds and government securities. The tax rates for short-term and long-term capital gains for debt funds are as follows:

  • Short-term capital gains (holding period less than 36 months): Taxed at the investor's income tax slab rate.
  • Long-term capital gains (holding period 36 months or longer): Taxed at the investor's income tax slab rate.

Starting from 1st April 2023, debt funds will no longer receive indexation benefit and will be deemed as short-term capital gains. Therefore, gains from debt funds will be added to the investor's taxable income and taxed at the applicable slab rate.

Hybrid Funds

Hybrid funds have a combination of both equity and debt instruments. The taxation of capital gains on hybrid funds depends on the equity exposure of the portfolio. If the equity exposure exceeds 65%, the fund scheme is taxed like an equity fund. If not, the rules of taxation for debt funds apply.

Taxation of Mutual Funds by Type

Let's summarize the tax rates for different types of mutual funds:

Fund Type

STCG Tax Rate (Before 31 March 2023)

LTCG Tax Rate (Before 31 March 2023)

STCG Tax Rate (After 31 March 2023)

LTCG Tax Rate (After 31 March 2023)

Equity Mutual Fund

15%

10% without indexation

15%

10% without indexation

Debt Mutual Fund

Investor's income tax slab rate

20% with indexation

Investor's income tax slab rate

Investor's income tax slab rate

Hybrid Equity-oriented Funds

15%

10% without indexation

15%

10% without indexation

Hybrid Debt-oriented Funds

Investor's income tax slab rate

20% with indexation

Investor's income tax slab rate

Investor's income tax slab rate

It is important to note that the tax rates mentioned above are subject to change as per the prevailing tax laws.

Taxation of Mutual Funds when Invested Through SIPs

Systematic Investment Plans (SIPs) are a method of investing in mutual funds. With SIPs, investors can invest a small amount periodically in a mutual fund scheme. The taxation of capital gains through SIPs is determined by the holding period.

If an investor redeems their entire investment after 12 months or longer, they realize long-term capital gains. Long-term capital gains up to Rs 1 lakh per year are tax-exempt. Any gains exceeding this limit are taxed at a rate of 10% without indexation benefit.

On the other hand, if an investor redeems their units within the first 12 months, they incur short-term capital gains. Short-term capital gains from SIPs are taxed at a flat rate of 15%, irrespective of the investor's income tax slab. Additionally, applicable cess and surcharge are levied on the short-term capital gains.

Securities Transaction Tax (STT)

Apart from taxes on dividends and capital gains, there is another tax called the Securities Transaction Tax (STT). The government levies an STT of 0.001% when buying or selling mutual fund units of an equity fund or a hybrid equity-oriented fund. However, there is no STT on the sale of debt fund units.

Conclusion

Understanding the taxation of mutual funds is crucial for investors to make informed decisions and optimize their tax liabilities. The tax rates for mutual funds vary based on factors such as fund type, holding period, and the nature of gains. By considering these factors, investors can plan their investments effectively and maximize their tax efficiency.

Frequently Asked Questions:

Q: Are mutual fund taxes payable every year? A: Mutual fund taxes are applicable only when you redeem the units or sell the scheme. It is not payable every year. However, dividend income from mutual fund schemes is included in your total income for the financial year and is subject to income tax.

Q: Is it possible to avoid capital gains tax? A: It is not possible to completely avoid paying tax on capital gains. However, you can plan your investments strategically to be tax-efficient. For example, long-term capital gains are taxed at a lower rate compared to short-term capital gains. Understanding the types of taxes levied on mutual fund schemes can help you make informed investment decisions.

Q: What factors should be considered before choosing tax-saving mutual funds? A: When selecting tax-saving mutual funds, consider the mode of investment, asset allocation, tax-exemption limits, and the lock-in period. These factors play a crucial role in determining the suitability of a tax-saving mutual fund for your financial goals.

Q: Can mutual fund investments help me get a rebate on income tax? A: Yes, under Section 80C of the Income Tax Act, tax benefits are applicable to Equity Linked Saving Schemes (ELSS). Investing in ELSS can provide tax deductions of up to Rs. 1.5 lakh, helping you save on taxes. However, ELSS has a minimum lock-in period of three years.

Q: Are wealth taxes applicable to mutual fund investments? A: Mutual funds and other financial assets are exempt from wealth taxes as per the Wealth Tax Act. Therefore, you do not need to pay wealth tax on your mutual fund investments.

Q: What is Section 54EA regarding capital gains tax exemptions? A: According to Section 54EA, if a long-term capital asset is transferred before 1st April 2000 and the proceeds are invested in specific bond shares within six months of the transfer date, there is an exemption from capital gains tax as computed under Section 54F.

Q: What are tax-saving mutual funds? A: Tax-saving mutual funds, also known as Equity Linked Saving Schemes (ELSS), provide investors with the opportunity to save taxes under Section 80C of the Income Tax Act. Investing in ELSS can help you get tax deductions and potentially save a significant amount on taxes.

In conclusion, understanding how mutual funds are taxed is essential for investors to make informed decisions and optimize their tax liabilities. By considering the factors that influence mutual fund taxation and staying updated with the current tax regulations, investors can effectively plan their investments and maximize their returns.

Remember to consult with a tax advisor or financial professional for personalized guidance based on your specific financial situation and investment goals.

author

The Tax Heaven

Mr.Vishwas Agarwal✍📊, a seasoned Chartered Accountant 📈💼 and the co-founder & CEO of THE TAX HEAVEN, brings 10 years of expertise in financial management and taxation. Specializing in ITR filing 📑🗃, GST returns 📈💼, and income tax advisory. He offers astute financial guidance and compliance solutions to individuals and businesses alike. Their passion for simplifying complex financial concepts into actionable insights empowers readers with valuable knowledge for informed decision-making. Through insightful blog content, he aims to demystify financial complexities, offering practical advice and tips to navigate the intricate world of finance and taxation.

Frequently Asked Questions

Understanding mutual fund taxation is crucial for investors to accurately assess the tax implications of their investments and make informed decisions regarding their financial portfolios.

Capital gains from mutual funds are classified as either short-term or long-term based on the holding period of the investment.

Short-term capital gains on mutual funds are taxed at the investor's applicable income tax rate, while long-term capital gains are taxed at different rates depending on whether the mutual fund is equity-oriented or debt-oriented.

The Dividend Distribution Tax (DDT) is a tax levied on dividends declared by mutual funds. It impacts investors by reducing the amount of dividend income they receive from their mutual fund investments.

Tax-saving mutual funds, also known as Equity-linked Savings Schemes (ELSS), offer tax benefits under Section 80C of the Income Tax Act, allowing investors to claim deductions on their taxable income.

Subscribe to the exclusive updates!