Tax on Mutual Funds: How are Mutual Funds Taxed?

Mutual funds are highly regarded for their potential profitability, simplifying the achievement of financial goals. They offer tax efficiency, which is a key advantage. However, investing in mutual funds without considering the tax on mutual funds can lead to suboptimal outcomes.

Investors must consider factors beyond taxation, such as taxes on dividends and redemptions, as these can significantly affect cash flow. Understanding mutual fund taxation also aids in strategically planning investments to minimise overall tax liabilities. This blog explores the different aspects of mutual fund taxation, providing essential insights for investors.

What is Tax on Mutual Funds?

When investing in mutual funds, investors must consider the tax implications. Any profit 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 the units for less than three years. They are taxed according to your Income Tax Rate. On the other hand, gains from units held for more than three years are categorised as Long-Term Capital Gains (LTCG) and are taxed accordingly.

Factors Affecting Mutual Fund Taxation

Mutual fund taxation hinges on a few key factors:

• Fund Types: Mutual Funds are categorised into equity-oriented and debt-oriented Funds for tax purposes.
• Capital Gains: This refers to profits made when selling a capital asset for more than its purchasing cost.
• Distribution: Formerly known as dividends, distributions are now termed ‘Income Distribution cum Capital Withdrawal Plan’ or IDCW Plan after SEBI changed its nomenclature on 1st April 2024. These are portions of accumulated profits distributed to investors without requiring them to sell their assets.
• Holding Period: The holding period for investments can impact the tax you pay on capital gains. Longer holding periods generally result in lower tax liabilities, aligning with India’s tax policies and encouraging sustained investments.

How are Mutual Fund Returns Earned? 

Mutual fund investing allows investors to benefit from either capital gains or dividend income. Let’s define these terms and explore their differences.

• Capital Gains: Capital gains refer to the profit from selling an asset for more than its purchase price. This gain is realised in mutual funds only when the fund units are redeemed. Consequently, the capital gains tax on mutual funds is payable when redemption becomes due for the upcoming fiscal year’s income tax returns.
• Dividends: Another way investors earn from mutual funds is through dividends. These are payments made to investors from the fund’s distributable surplus. When investors receive dividends from their mutual funds, these are immediately subject to taxation. Thus, investors must pay tax on the dividends received.

Note: On 1st April 2021, the Securities and Exchange Board of India (SEBI) renamed mutual fund dividends. Dividends are now referred to as ‘distributions’. The dividend plan of mutual fund schemes is now called the ‘Income Distribution cum Capital Withdrawal Plan’ (IDCW Plan).

Taxation on Dividends Offered by Mutual Funds

The Finance Act of 2020 brought about an amendment that eliminated the Dividend Distribution Tax (DDT). Previously, until 31st March 2020, dividend income from mutual funds was tax-free for investors. Fund houses that declared dividends deducted a Dividend Distribution Tax (DDT) before distributing it to mutual fund investors. Additionally, on 1st April 2021, SEBI has renamed mutual fund dividends. Dividends are now referred to as ‘distributions’. The dividend plan of mutual fund schemes is now called the ‘Income Distribution cum Capital Withdrawal Plan’ (IDCW Plan).

However, the investor is now liable for the entire dividend income after this change. This is according to their income tax on mutual funds slab, categorised under “income from other sources.”

Tax Deducted at Source (TDS) also applies to dividends distributed by mutual fund schemes. Under the revised mutual fund rules, when a mutual fund holding distributes dividends to its investors, the Asset Management Company (AMC) must withhold 10% TDS under section 194K if the total dividend paid to an investor surpasses ₹5,000 during a financial year. 

When fulfilling their tax obligations, investors can claim credit for the 10% TDS already deducted by the AMC and only settle the remaining balance.

Taxation on Capital Gains Provided by Mutual Funds

The mutual fund capital gains tax depends on the type of schemes you’ve invested in and the duration of your holding of scheme units.

Firstly, let’s clarify the meanings of long-term capital gain on mutual funds (LTCG) and short-term capital gain tax on mutual funds (STCG). Tax on LTCG pertains to the capital gain tax on mutual funds accrued from an asset held for an extended period, typically investments held over a year. Conversely, short-term capital gain on mutual funds or STCG on equity funds refers to the capital gain from assets held for a relatively shorter duration, typically less than a year.

Regarding tax treatment, the definitions of “long” and “short” durations differ for equity and debt fund schemes. For instance, to qualify for long-term capital gains on mutual funds, you must hold your investment for at least 12 months in equity-oriented schemes, while it’s 36 months for debt-oriented schemes. 

The table below provides an overview of the required holding periods for capital gains to be considered long-term or short-term:

Types of Mutual Funds	STCG Holding Period	LTCG Holding Period
Equity Funds	Less Than 12 Months	More Than 12 Months
Debt Funds	Always Short-Term	Always Short-Term
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 funds are mutual funds in which over 65% of the total fund value is invested in equity shares of companies. As explained earlier, if you redeem your mutual fund equity units within one year, you incur short-term capital gains, taxed at a flat rate of 15%, regardless of your income tax mutual funds bracket.

On the other hand, when you sell mutual fund units after holding them for more than one year, you realise long-term capital gains. Up to Rs 1 lakh annually, these gains are exempt from tax. However, long-term capital gains exceeding this limit are subject to a 10% LTCG tax without the taxation of equity mutual funds benefit of indexation.

Taxation on Capital Gains Offered by Debt Funds

Taxation of Debt Mutual Funds After April 1, 2023

The 2023 Budget introduced changes affecting the taxation of Specified Mutual Funds. From April 1, 2023, debt mutual funds no longer benefit from indexation when calculating long-term capital gains (LTCG). Instead, these gains are taxed at the applicable income tax slab rates.

This change also applies to gold mutual funds, hybrid mutual funds, international equity mutual funds, and funds of funds (FOF). As a result, investors might prefer investing directly in debt securities to avoid mutual fund management fees. Higher taxes on profits may deter investors, reducing the appeal of these mutual funds.

Taxation of Debt Mutual Funds Before April 1, 2023

Previously, the taxation of debt mutual funds depended on the holding period:

• Short-Term Capital Gains (STCG): If sold within 36 months of purchase, gains were considered short-term and taxed at slab rates.
• Long-Term Capital Gains (LTCG): If sold after 36 months, gains were considered long-term and taxed at 20% with the indexation benefit. Indexation adjusts gains for inflation, reducing the tax burden.

Taxation on Capital Gains Provided by Hybrid Funds

The tax rate on capital gains for hybrid or balanced funds depends on the portfolio’s equity exposure. If the equity exposure is over 65%, the fund is taxed like an equity fund. If it is 65% or less, debt fund tax rules apply.

Knowing the equity exposure of your hybrid scheme is crucial to avoid unexpected taxes when you redeem your units. The table below summarizes the tax rates for mutual fund capital gains:

Types of Fund	Short Term Capital Gains	Long-Term Capital Gains
Equity funds	15% + cess & surcharge	Gains above Rs 1 lakh is taxed at 10% + cess + surcharge
Debt funds	According to the Investor’s income tax slab rate	According to the Investor’s income tax slab rate
Hybrid equity-oriented funds	15% + cess & surcharge	Gains above Rs 1 lakh is taxed at 10% + cess + surcharge
Hybrid debt-oriented funds	According to the Investor’s income tax slab rate	According to the Investor’s income tax slab rate

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.

With each SIP instalment, you acquire a specific number of mutual fund units, and upon income tax on mutual funds redemption, the units are liquidated on a first-in-first-out basis. For instance, if you invest in an equity fund through SIPs for one year and redeem your entire investment after 13 months, the units purchased initially through SIPs qualify as long-term holdings (over one year). Any long-term capital gains on these units under Rs 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.

Taxation on Capital Gains When Investing in Tax Saving Mutual Funds or ELSS

Equity-Linked Savings Scheme (ELSS) is a mutual fund that invests at least 80% of its funds in stocks. ELSS offers an attractive option for those looking at the tax benefits of mutual funds. Investing in ELSS allows you to deduct up to Rs 1.5 lakh from your taxable income under section 80C of the Income Tax Act, 1961.

However, the total deductions under section 80C have a maximum limit of Rs 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, during which you cannot withdraw your investment. After this period, you can withdraw your funds, and any gains will be subject to long-term capital gains (LTCG) tax rather than short-term capital gains (STCG) tax. Additionally, you can take a loan against your ELSS investment.

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%. However, the sale of Debt Fund units is not subject to STT.

Things to Remember When Looking at Tax on Mutual Funds

When researching mutual fund taxation, remember the following:

1. Mutual funds are taxed based on asset classification and investment duration.
2. Equity-oriented funds incur a 15% short-term capital gains tax for holdings up to 12 months. Beyond that, a 10% long-term capital gains tax applies for gains exceeding ₹1,00,000.
3. Debt mutual funds are taxed according to your income slab for investments up to 36 months. Afterwards, a 20% long-term capital gains tax applies, adjusted for inflation.
4. Equity-linked savings schemes offer tax deductions of up to ₹1,50,000 annually.
5. Dividends from mutual funds are taxable for investors.
6. Mutual funds deduct TDS on distributed dividends at a rate of 10% for resident investors and 20% (plus applicable surcharge and cess) for non-resident investors.

How Do Investors Declare Mutual Fund Investments in ITR?

If you’ve made capital gains or losses in a financial year, you must report them by filing ITR Form 2 or 3 (if ineligible for ITR 2). Capital gains from mutual funds are taxed when units are redeemed. Those earning capital gains must file ITR 2, while individuals earning from business or profession must file ITR 3.

Capital gains signify the difference between purchase and sale prices between mutual fund units. If the sale price exceeds the purchase price, it’s a gain; if it’s lower, it’s a loss. The Income Tax Act allows adjusting losses with profits, with long-term losses against long-term gains and short-term losses against both types.

How to report capital gains in ITR?

Individuals receiving capital gains from the sale of equity must file IT returns annually. This can be done online through the official Income Tax Department portal. Here’s a concise, step-by-step guide:

1. Log In: Visit the Income Tax Department website and log in with your credentials.
2. Navigate: Follow this path: e-File > Income Tax Returns > File Income Tax Returns.
3. Select Details: Choose the assessment year, status, and form type. Select ‘Taxable income is more than basic exemption limit’ as the reason for filing.
4. Schedules: Select ‘General’ and click on ‘Income Schedule’. Then, choose ‘Schedule Capital Gains’ and select the type of capital assets.
5. Short-Term Capital Gains (STCG): STCG from selling listed equity shares is taxed at 15% under Section 111A. If your total taxable income, excluding STCG, is below Rs. 2.5 lakh, the shortfall is adjusted with STCG. The remaining STCG is taxed at 15% plus a 4% cess. Click ‘Add details’ and provide the consolidated amount from the sale of short-term assets along with the Cost of Acquisition (COA).
6. Long-Term Capital Gains (LTCG): LTCG from the sale of equity and related instruments is taxed at 10% under Section 112A, with gains up to Rs. 1 lakh tax-free. Provide scrip-wise details, including ISIN, selling price, purchase price, and transaction dates. Click ‘ Add ‘ after entering these details in ‘Schedule 112A’.
7. Review and Preview: Confirm the necessary schedules, review Part B TTI, and click ‘Preview Return.’ Then, download the ITR and proceed with the declaration.
8. Declaration and Verification: Provide specific details in the declaration tab and click ‘Proceed to Validation’. Verify the ITR electronically or by sending a signed ITR-V printout to the Income Tax Department office in Bangalore. Ensure verification within 120 days of filing.

To Wrap It Up…

Mutual fund taxation is relatively straightforward as these funds are primarily based on the holding duration and whether the scheme is equity—or debt-oriented. However, it can become daunting to calculate everything manually when the tax return deadline is approaching. This is why investors might find it helpful to conduct thorough research into the taxation process of their chosen mutual funds. 

Frequently Asked Questions About Tax on Mutual Funds