Tax on Mutual Funds – A Complete Guide to Taxation and Rules
Mutual funds are designed to help investors achieve financial goals while offering tax efficiency. However, tax on mutual fund redemptions and taxes on dividends can impact overall returns. This blog explores the various aspects of mutual fund taxation in India, providing relevant insights for investors to consider.
What is Taxes on Mutual Funds?
The profit that the investors may make when selling mutual fund units is known as capital gains. Based on how long investors hold the units, these gains are classified into short-term and long-term.
Short-term gains apply if investors hold equity fund units for 12 months or less, and long-term gains apply if they are held for more than 12 months. For tax on equity mutual funds, short-term gains are taxed at 15% for transactions up to 22nd July, 2024, and at 20% thereafter; long-term gains above ₹1.25 lakh are taxed at 12.5%. For debt mutual funds, all capital gains are taxed at the investor’s income-tax slab rate, with no indexation benefit (applicable from April 1, 2023).
Factors Affecting Mutual Fund Taxation
Mutual fund taxation in India depends on a few key factors:
- Fund Types: Mutual funds are classified into equity and debt funds for tax purposes.
- Capital Gains: Profits made from selling a capital asset for more than its purchase cost.
- Distribution: Formerly dividends, now called ‘Income Distribution cum Capital Withdrawal Plan’ (IDCW) as per SEBI’s 2024 update. These are portions of accumulated profits distributed to investors without asset sales.
- Holding Period: The holding period affects the tax on mutual fund capital gains. Longer holding periods typically result in lower tax liabilities.
How are Mutual Fund Returns Earned?
Mutual fund returns come from two main sources: capital gains and dividends.
- Capital Gains: This refers to the profit earned when mutual fund units are sold for more than their purchase price. Capital gains tax on mutual funds is payable upon redemption of units in the next fiscal year’s income tax returns.
- Income Distribution cum Capital Withdrawal (IDCW): Previously called dividends, these payouts may consist of both income and capital from the fund’s surplus. Taxes on mutual fund distributions are applied upon receipt.
Note: From 1st April, 2021, SEBI renamed the ‘Dividend’ option in mutual funds to ‘Income Distribution cum Capital Withdrawal’ (IDCW) for better clarity, reflecting payouts that may include both income and capital. Terms like ‘Dividend Payout’ and ‘Dividend Reinvestment’ are now ‘Payout of IDCW’ and ‘Reinvestment of IDCW’.
Taxation on Capital Gains Provided by Mutual Funds
Capital gains tax on mutual funds depends on the type of scheme and the holding period. For equity mutual funds, long-term capital gains (LTCG) are applicable on assets held for more than 12 months, while short-term capital gains (STCG) are taxed on assets held for less than 12 months.
For debt mutual funds, LTCG applies when investments are held for over 36 months, with shorter durations taxed under STCG. Understanding tax implications helps with better tax planning, especially when considering tax-efficient mutual funds to lower your tax burden.
| Types of Mutual Funds | STCG Holding Period | LTCG Holding Period |
| Equity Funds | Less Than 12 Months | More Than 12 Months |
| Debt Funds | Less than 36 Months | More than 36 Months |
| Hybrid equity-oriented funds | Less Than 12 Months | More Than 12 Months or Longer |
| Hybrid debt-oriented funds | Always Short-Term | Always Short-Term |
Taxation on Equity Mutual Funds Capital Gains
Equity mutual funds are taxed based on the holding period. The budget 2024 has changed the rates and slabs:
- Short-Term Capital Gains (STCG): Gains from equity mutual funds held for less than 12 months are taxed at 20% (earlier 15%).
- Long-Term Capital Gains (LTCG): Gains from holdings above 12 months are tax-free up to ₹1.25 lakh per year. Gains above this limit are taxed at 12.5% without indexation.
No indexation means gains are taxed without inflation adjustment. Therefore, the long-term investors will pay more tax.
Taxation on Capital Gains Offered by Debt Funds
Debt mutual funds are taxed differently based on the holding period. The latest budget has removed the indexation benefit for long-term gains:
- Short-Term Capital Gains (STCG): Gains from units held for less than 36 months are taxed as per your income tax slab.
- Long-Term Capital Gains (LTCG): Gains from units held for more than 36 months are taxed at 12.5% without indexation.
Earlier, it was 20% with indexation. Now it’s flat 12.5% for all, regardless of amount or inflation.
Taxation on Capital Gains Provided by Hybrid Funds
Tax on hybrid mutual funds depends on the equity exposure:
- Equity-Oriented Hybrid Funds (≥ 65% equity)
- STCG (held < 12 months): Taxed at 20%.
- LTCG (held ≥ 12 months): Gains up to ₹1.25 lakh are tax-free; above that taxed at 12.5% without indexation.
- Debt-Oriented Hybrid Funds (< 65% equity)
- STCG (held < 36 months): Taxed as per the income tax slab.
- LTCG (held ≥ 36 months): Taxed at 12.5% without indexation.
This is same as the taxation of the dominant asset class.
Taxation on Capital Gain When Investing in SIPs
Systematic Investment Plans (SIPs) allow investors to periodically invest small amounts in mutual fund schemes, offering flexibility in choosing the investment frequency, such as weekly, monthly, quarterly, bi-annually, or annually.
Each SIP instalment purchases a specific number of mutual fund units, redeemed on a first-in-first-out (FIFO) basis for tax purposes. SIP tax follows the same principles as mutual fund taxation in India, with each instalment treated as a separate investment.
For example, if you invest in an equity fund through SIPs for a year and redeem after 13 months, the initial units qualify as long-term holdings (over one year), and any long-term capital gains under ₹1 lakh are tax-free.
On the other hand, units purchased through SIPs from the second month onward are considered short-term holdings, resulting in short-term capital gains. These gains are taxed at a fixed rate of 15%, irrespective of your income tax bracket, with applicable cess and surcharge added to the tax amount.
If debt fund units are redeemed within three years, they are subject to short-term capital gains tax in mutual funds. If held for over three years, they incur a 20% flat rate with indexation, reducing taxable gains for inflation.
Taxation on Capital Gains When Investing in Tax Saving Mutual Funds or ELSS
ELSS is a mutual fund that invests at least 80% of its assets in stocks, offering tax benefits. You can deduct up to ₹1.5 lakh from taxable income under Section 80C of the Income Tax Act, 1961.
However, the total deductions under section 80C have a maximum limit of ₹1.5 lakh. If you claim deductions for other expenses under this section, the deductible amount for ELSS investments will be reduced accordingly.
ELSS has a three-year lock-in period, after which you can withdraw your funds. Any gains will be subject to LTCG tax instead of STCG tax. You can also take a loan against your ELSS investment.
In Budget 2024-25, the LTCG exemption limit was raised to ₹1.25 lakh, and the LTCG tax rate increased to 12.5%.
STT or Securities Transaction Tax
The Securities Transaction Tax (STT) differs from Capital Gains and Dividend Taxes. When you purchase or sell units of an Equity Fund or a Hybrid Equity-Oriented Fund, the Ministry of Finance imposes an STT at 0.001%. For securities transaction tax mutual funds, this tax applies primarily to equity-related funds, but the sale of Debt Fund units is not subject to STT.
Things to Remember When Looking at Taxes on Mutual Funds
When researching mutual fund taxation, remember the following:
- Mutual funds are taxed based on asset classification and investment duration.
- Equity-oriented funds incur a 20% short-term capital gains tax for holdings up to 12 months. After 12 months, long-term capital gains tax on mutual funds is 12.5% for gains exceeding ₹1,00,000.
- Debt mutual funds are taxed according to your income slab for investments up to 36 months. Afterwards, a 12.5% long-term capital gains tax applies.
- Equity-linked savings schemes offer tax deductions of up to ₹1,50,000 annually.
How Do Investors Declare Mutual Fund Investments in ITR?
Here’s how investors declare mutual fund gains and losses in ITR:
- Report capital gains or losses by filing ITR Form 2 or Form 3 (if ineligible for ITR 2).
- Capital gains from mutual funds are taxed upon the redemption of units.
- ITR 2 is required for those earning capital gains; ITR 3 is for those with business or professional income.
- Capital gains are the difference between the purchase and sale prices of mutual fund units.
- A gain occurs when the sale price exceeds the purchase price, and a loss occurs when the sale price is lower.
- The Income Tax Act allows adjusting losses: long-term losses offset long-term gains, and short-term losses offset both.
How to Report Capital Gains in ITR?
If you have sold equity and have capital gains, you need to file ITr annually. You can do it online through the Income Tax Department portal. Here’s how:
- Log in to Income Tax Department website: Login to the Income Tax Department website with your credentials.
- Navigate: Go to e-File > Income Tax Returns > File Income Tax Returns.
- Select Details: Choose the assessment year, status and form type. Select ‘Taxable income is more than basic exemption limit’ as the reason for filing.
- Schedules: Select ‘General’ and click on ‘Income Schedule’. Then, choose ‘Schedule Capital Gains’ and select the type of capital assets.
- Short-Term Capital Gains (STCG): STCG from selling listed equity shares is taxed at 15% under Section 111A. If your taxable income (excluding STCG) is below ₹2.5 lakh, the shortfall is adjusted against STCG. The remaining STCG is taxed at 15% plus cess. Click ‘Add details’ to enter the sale amount from short-term assets and Cost of Acquisition (COA).
- Long-Term Capital Gains (LTCG): LTCG from the sale of equity and related instruments is taxed at 10% under Section 112A, with up to ₹1 lakh exempt from tax. Enter details for each scrip, including ISIN, selling price, purchase price and transaction dates. Click ‘Add’ after entering the details in ‘Schedule 112A’.
- Review and Preview: Confirm the schedules, review Part B TTI and click ‘Preview Return’. Then, download the ITR and proceed with the declaration.
- Declaration and Verification: Enter the details in the declaration tab and click ‘Proceed to Validation’. Verify the ITR electronically or send a signed ITR-V printout to the Income Tax Department office in Bangalore. Verify within 120 days of filing.
To Wrap It Up…
Mutual fund taxation in India depends on the holding period and whether the scheme is equity- or debt-oriented. Calculating tax manually near the deadline can be challenging. This is why investors might find it helpful to conduct thorough research about the process of calculating tax on mutual fund redemption.
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Frequently Asked Questions About Tax on Mutual Funds
If you’re wondering, “Is a mutual fund tax-free?”, the answer is no. The earnings are taxed as ‘capital gains.’ Understanding tax on mutual fund income is crucial before investing, as it impacts returns. Additionally, tax on mutual fund returns varies depending on the type of fund and holding period.
SIPs in ELSS are tax-deductible under Section 80C. For debt funds, tax on mutual fund SIPs is based on the holding period, whereas the hybrid and international funds follow the same tax rules as equity funds.
Tax on mutual fund investments is on profits (capital gains) from the sale of units. Long-term capital gains (LTCG) tax is applicable on equity mutual funds held for more than a year, whereas debt mutual funds require 36 36-month holding period.
Mutual fund taxes are applicable on unit redemption or sale, not annually. The gains from the sale are taxed based on the holding period and applicable capital gains tax rules.
Section 54EA allowed reinvestment in specific bonds for long-term assets transferred before April 1, 2000. Since it’s no longer in force, taxpayers use sections like 54EC or 54F for exemptions.
Section 10 (exempt u/s 10) lists out various mutual fund tax exemptions in India, such as:
– Agricultural Income (Section 10(1))
– Life Insurance Receipts (Section 10(10D))
– Provident Fund Withdrawals (Section 10(11) & 10(12))
– Gratuity (Section 10(10))
– Leave Encashment (Section 10(10AA))
– House Rent Allowance (HRA) (Section 10(13A))
– Scholarships (Section 10(16))
– Minor’s Income (Section 10(32))
These incomes are subject to specific conditions and limits.
