Tax on Mutual Funds- How are Mutual Funds Taxed?
Investors rely on Mutual Funds for their potential profitability in achieving financial goals. One of their standout advantages is their tax efficiency, making them an attractive investment avenue. Investing in Mutual Funds can yield tax-efficient returns, a key benefit to consider. However, it’s crucial not to overlook the impact of taxes, as doing so might lead to incorrect investment decisions.
In addition to taxation, investors should account for various other factors, like dividend and redemption taxes, which can significantly affect cash flow. Furthermore, understanding Mutual Fund taxation is essential for strategic investment planning to reduce overall tax liabilities.
This blog is your comprehensive guide to navigating the intricacies of what is mutual fund taxation.
What is Tax on Mutual Funds?
Mutual fund taxation entails the tax responsibilities related to mutual fund income investments. Investors typically categorize capital gains from selling mutual fund units within three years. As short-term capital gains are subject to their income tax rate. However, holding them for over three years reclassifies the gains as long-term capital gains.
Understanding ‘Tax on Mutual Funds’ allows you to strategize your investments to minimize your overall tax liability. Additionally, you can explore potential tax deductions in certain situations. Therefore, staying informed about mutual fund tax regulations is essential when investing.
Factors Influencing Debt Mutual Fund Taxation
Mutual fund taxation hinges on several key factors. These factors make it easier to comprehend the subject of ‘Debt Funds Taxation’. You can summarise them in the following way:
Mutual Fund Types
Mutual funds come in two primary categories for tax purposes:
- Debt-Oriented Funds: These funds primarily invest in fixed-income instruments like bonds and face different tax on debt funds treatment compared to tax on equity-oriented funds.
- Equity-Oriented Funds: These mainly invest in stocks and enjoy preferential tax on stocks treatment, especially for long-term holdings.
Dividends
Different Mutual funds may distribute a portion of their profits to investors in the form of dividends.
You can further categorize these dividends into:
- Dividend Distribution Tax (DDT): The tax levied on the mutual fund house for distributing dividends before handing them over to investors.
- Dividend Income: The dividends received by investors are typically tax-free in their hands.
Holding Period
The duration for which an investor holds units of mutual funds significantly impacts the tax implications:
- Longer holding periods are generally more tax-efficient. Additionally, they may qualify for preferential tax treatment such as lower LTCG tax rates and indexation benefits for debt-oriented funds.
- Investors who hold their units for the long term tend to enjoy reduced tax liabilities. Consequently, making it a crucial consideration in tax planning.
Capital Gains
Debt Mutual Funds taxation capital gains depends on the holding period:
- Short-Term Capital Gains (STCG): Profits from the sale of units held for less than one year are subject to short-term capital gains tax at the investor’s applicable income tax rate.
- Long-Term Capital Gains (LTCG on mutual funds): Depending on the different types of mutual funds, gains from units held for more than one year may receive a lower tax rate or full tax exemption. You can categorise the type of funds into:
(a) For equity-oriented funds, Long term capital gain on mutual funds is generally tax-free up to a certain threshold with the introduction of the Long-Term Capital Gains Tax (LTCG Tax on mutual funds).
(b) Debt-oriented funds apply a flat rate for taxing long term capital gain tax on mutual funds, with the advantage of indexation benefits, significantly reducing the tax liability.
How are Mutual Fund Returns Earned?
Mutual fund investing provides an opportunity for investors to generate tax on mutual fund returns through either Capital Gains or Dividend Income. A good example of mutual fund tax benefit is ELSS tax saving, which offers tax benefits and good returns. Let’s clarify these concepts and explore their distinctions in more depth.
Capital Gain, in essence, refers to the profit obtained from selling mutual funds or an asset at a higher price than its original cost.Capital gains occur only when you redeem Mutual Fund units. Consequently, the tax obligation for Mutual Fund Capital Gains arises solely upon tax on mutual fund redemption.
So, investors settle taxes on Mutual Funds redemptions when they file their income tax returns for the next fiscal year.
Another avenue for Mutual Fund investors to earn income is through Dividends. The Mutual Fund declares these dividends based on its available distributable surplus.
Once disbursed to investors, Dividends are subject to immediate taxation, in line with the Mutual Fund’s discretion. Consequently, investors are liable to pay taxes on Dividends received from their Mutual Funds. The following section provides insights into both past and current regulations governing Mutual Fund dividend taxation. Let’s now begin to learn about how mutual funds are taxed.
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 March 31, 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.
However, after this change, the entire dividend income is now taxable in the hands of the investor. This is according to their income tax on mutual funds slab, categorized under the “income from other sources.”
Additionally, Tax Deducted at Source (TDS) 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. That is 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 mutual fund scheme you’ve invested in and the duration for which you’ve held the 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). LTCG pertains to the capital gain tax on mutual funds accrued from an asset held for an extended period, indicating a lengthy holding period. Conversely, short term capital gain on mutual funds or STCG refers to the capital gain from assets held for a relatively shorter duration.
The definitions of “long” and “short” durations differ for equity and debt fund schemes regarding tax treatment. 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 Fund | 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 |
| Hybrid debt-oriented funds | Less Than 36 Months | More Than 36 Months |
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 realize long-term capital gains. These gains, up to Rs 1 lakh per year, are exempt from tax. However, any 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 for debt-oriented mutual funds is relatively straightforward and provides superior tax efficiency compared to conventional investments like fixed deposits.
Let’s look at the LTCG tax and STCG tax on debt mutual funds separately.
- Long Term Capital Gain on Debt Mutual Funds: Debt schemes are subject to LTCG tax under section 112 of the Income Tax Act, 1961, at a rate of 20% with the advantage of indexation benefits. These debt fund taxation benefits enhance the tax in mutual fund efficiency of debt mutual fund schemes by accounting for the price rise (inflation) through the Cost Inflation Index (CII) provided by tax departments.
- Short Term Capital Gains on Debt Mutual Funds: STCG on debt mutual funds is levied based on the taxpayer’s income tax slab. For example, if your total income, excluding short capital gains debt mutual funds, is already above ₹10,00,000 and you fall into the highest tax bracket of 30%, your short-term capital gains taxability of mutual funds rate will be 30%, plus applicable cess and surcharge.
Taxation on Capital Gains Provided by Hybrid Funds
The taxation of capital gains on hybrid or balanced funds hinges on the equity exposure of the portfolio. If the fund’s equity exposure exceeds 65%, it falls under the tax regime applicable to equity funds. Conversely, if the equity exposure is less than 65%, the taxation of mutual funds rules for debt funds come into play. This differentiation is crucial for investors, as it significantly impacts the tax implications when redeeming fund units.
Understanding the equity exposure of the hybrid scheme you’re investing in is essential. Failing to do so may lead to unexpected tax outcomes when you decide to redeem your fund units. To ensure you’re well-informed about the tax implications of your investment, it’s advisable to review the fund’s equity exposure and consult with a financial advisor if needed.
Below is the summarized the rate of taxation on mutual funds of capital gains in the form of a table:
| 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 installment, 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
Investing in an ELSS fund entitles you to a tax deduction of up to ₹1,50,000 under Section 80C of the Income Tax Act, 1961. This fund, primarily focused on equities, offers a compelling tax-saving opportunity with its three-year lock-in period and promising returns, making it a top choice for investors.
STT or Securities Transaction Tax
The Securities Transaction Tax (STT) is distinct 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 a rate of 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:
- Mutual funds are taxed based on asset classification and investment duration.
- 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.
- Debt mutual funds are taxed according to your income slab for investments held up to 36 months. Afterward, a 20% long-term capital gains tax applies, adjusted for inflation.
- Equity-linked savings schemes offer tax deductions up to ₹1,50,000 annually.
- Dividends from mutual funds are taxable for investors.
- Mutual funds deduct TDS at a rate of 10% for resident investors and 20% (plus applicable surcharge and cess) for non-resident investors on distributed dividends.
How to Declare Mutual Fund Investments in ITR?
If you’ve made capital gains or losses in a financial year, you must report them by filing either 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 of 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?
To report capital gains in ITR:
- Log in to the Income Tax Department’s website.
- Choose ‘e-file’ > ‘Income Tax Returns’ > ‘File Income Tax Returns’.
- Select assessment year, status, and form type.
- Choose ‘taxable income is more than exemption limit’ as reason.
- Select ‘General’ > ‘Income Schedule’ > ‘Schedule Capital Gains’ and asset type.
- For short-term gains, add total sale amount and Cost of Acquisition.
- For long-term gains, provide scrip-wise details in ‘Schedule 112A’.
- Confirm schedules, preview return, download ITR, and make declaration.
- Provide specific details, validate, file ITR, and e-verify electronically.
- Processing usually completes within 120 days after filing.
To Wrap It Up…
Mutual fund taxation is relatively straightforward, primarily hinging 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 just around the corner.
Nevertheless, investors can cut down on their tax liabilities and build their corpus by opting for tax-saver funds. Whether acquired through a lump sum or SIP, the taxation remains consistent for this fund type. Yet, long-term investments could yield greater tax efficiency compared to short-term holdings.
FAQs
Earnings from mutual fund investments are taxed as ‘Capital gains,’ making it crucial to grasp the tax implications before investing. Additionally, certain situations may allow for tax deductions, However, income from mutual fund is taxable in India, mostly.
SIP in Equity Linked Saving Schemes (ELSS) falls under the EEE (Exempt, Exempt, Exempt) or mutual fund tax exemption category. This means that the investment amount, maturity proceeds, and tax on mutual funds withdrawals are all tax-free, allowing you to invest in ELSS SIPs as tax-free mutual funds.
Investors can enjoy a tax exemption of up to Rs 1 lakh annually. Starting from April 1st, 2023, all capital gains will be subject to taxation in mutual funds based on the investor’s mutual funds income tax slab rate.
Taxes in mutual fund schemes are usually incurred upon unit redemption or sale, not yearly. Yet, dividends received in the current fiscal year are part of your total income and may be taxed if your overall income is taxable.
Under Section 54EA, if you transfer a long-term asset before April 1, 2000, and reinvest in specific bonds within six months, you can be exempt from capital gains as per Section 54F.F.
