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 returns that are tax-efficient, 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. As they can affect cash flow significantly. Furthermore, understanding Mutual Fund taxation is essential for strategic investment planning aimed at reducing overall tax liabilities. 

This blog is your comprehensive guide to navigating the intricacies of tax on mutual funds. 

What is ‘Tax on Mutual Funds’?

Mutual fund taxation entails the tax responsibilities related to mutual fund 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:

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 treatment compared to equity-oriented funds.
• Equity-Oriented Funds: These mainly invest in stocks and enjoy preferential tax treatment, especially for long-term holdings.

Dividends

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 mutual fund units 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 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): Depending on the type of fund, 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:

1. For equity-oriented funds, LTCG is generally tax-free up to a certain threshold with the introduction of the Long-Term Capital Gains Tax (LTCG Tax).
2. Debt-oriented funds apply a flat rate for taxing LTCG, 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 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 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 redemption.
So, investors settle taxes on Mutual Fund 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.

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 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 rules, when a mutual fund 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 capital gains tax on mutual funds 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 gains (LTCG) and short-term capital gains (STCG). LTCG pertains to the capital gain accrued from an asset held for an extended period, indicating a lengthy holding period. Conversely, 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 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:

Taxation on Capital Gains Offered by Equity funds

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 equity fund units within one year, you incur short-term capital gains, taxed at a flat rate of 15%, regardless of your income tax bracket.

On the other hand, when you sell your equity 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 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 benefits enhance the tax 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 STCG, is already above ₹10,00,000 and you fall into the highest tax bracket of 30%, your short-term capital gains tax 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 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 of capital gains on mutual funds in the form of a table: 

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 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.

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.

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.

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