Mutual Fund Taxation: How Different Mutual Funds Are Taxed and Other Benefits

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Mutual funds are often promoted as a good way to build wealth over time. However, the gains made when mutual fund units are redeemed attract taxes. One must understand the tax implications on their mutual fund investments to be able to evaluate the actual returns one makes through investing in mutual funds. In this article, let’s understand tax on mutual funds. 

This article covers:

How do mutual funds reward us?

Investors are rewarded in two ways in lieu of their mutual fund investments:

  • Dividends: Dividends are the share of profits that companies willingly distribute among the shareholders who have invested in the company. 
  • Capital Gains: Capital gains are any profit or earnings made by the investor when they liquidate their mutual fund holdings, and the selling price is higher than what was paid at the time of buying. If the selling price is lower than the buying price, a capital loss arrives, and obviously, losses are not taxed. Instead, losses are eligible for set-off.

Coming back to taxation, both dividend income and capital gains arising from mutual funds are subject to taxes.  

Tax implications on dividends from mutual funds 

Until 31 Mar 2020, the dividend income was tax-exempt in the receiver’s hands; the companies paying out dividends were supposed to pay a Dividend Distribution Tax.

However, the Finance Act 2020 brought about many changes in the process of taxation on dividends. With effect from 1 Apr 2020, dividends received from mutual funds are subject to Tax Deduction at Source (TDS) @ 10% if the dividend income from a mutual fund is more than Rs 5,000. However, as a COVID-19 relief measure, the government reduced the TDS rate to 7.5% for distribution from 14 May 2020 until 31 Mar 2021.

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The dividend earned is also subject to taxation according to the tax slab of the assessee, i.e., the dividend earned through mutual funds is added to the taxable income, and tax is calculated according to the tax slab the investor belongs to. 

From 1 Apr 2020, dividends received from mutual funds are subject to TDS @ 10% if the dividend is more than Rs 5,000. However, as a Covid-19 relief measure, the govt reduced the TDS rate to 7.5% for distribution from 14 May 2020 until… Click To Tweet

Tax implications on capital gains from mutual funds

Depending upon the holding period of investment, gains from mutual funds are bifurcated into:

Taxes vary significantly depending upon the type of capital gains – short term or long term – and also upon the type of mutual fund – equity or debt. 

Taxes on capital gains from equity-oriented funds

An equity-oriented mutual fund has more than 65% of its corpus invested in the equity of domestic companies. 

Short-term capital gains arising from equity funds are taxed at a flat 15%. This taxation has nothing to do with the tax bracket of the individual. Remember, short-term capital gains in equity funds arise when investments are liquidated within one year of purchase.

Long-term capital gains in equity funds arise when investments having a holding period of more than 12 mth, are redeemed. Long-term capital gains are taxed at a flat 10%, for gains in excess of Rs 1 lakh. This means, there is no tax should your long-term capital gain from equity mutual funds be less than Rs 1 lakh in a year. Cess and surcharge are additionally charged. 

Example for STCG: Mr A sold his equity fund held for 2 yrs and realized a profit of Rs 3 lakh. 

His short-term capital gain tax would be 15% of Rs 3 lakh + cess

Tax liability for Mr A =  Rs 3,00,000 x 15.6% = Rs 46,800

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Example for LTCG: Mr A sold his equity fund held for 2 yrs and realized a profit of Rs 3 lakh. 

His long-term capital gains would be applicable on the excess gains over Rs 1 lakh = 2 lakh

The rate applicable would be 10% + cess. 

Tax liability for Mr A = Rs 2,00,000 x 10.4%= Rs. 20,800

Taxes on Debt funds 

Debt funds are those having their investments parked in several fixed income-generating securities. When debt funds with a holding period of 36 mth are realized, the profit so arrived is short-term capital gains. There’s no separate taxation route for short-term capital gains from debt funds. The gains are added to the individual’s taxable income and are subject to taxation based on the individual’s tax slab.

When held for more than 36 mth, long-term capital gains from debt funds attract taxes at the rate of 20%, but the benefit of indexation is available. Cess and surcharge are charged additionally. 

Taxes on hybrid funds

A hybrid fund has the properties of both an equity-oriented fund and a debt fund. Capital gains from hybrid funds are taxed either like equity funds or debt funds depending on the structure of the hybrid fund. If the equity exposure of the hybrid fund is a minimum of 65%, it is taxed exactly like an equity-oriented fund. Otherwise, it is taxed like a debt fund. 

Taxes on equity linked saving schemes (ELSS)

ELSS funds are known as tax-saving mutual funds. Investments in ELSS funds are eligible for deduction up to Rs. 1,50,000 under Section 80C of the Income Tax. Investors belonging to the highest tax bracket may be able to save up to Rs 46,350 in taxes (Rs 1.5 lakh x 30.9% tax + cess) by investing in an ELSS fund. 

Taxes on systematic investment plans (SIP)

SIPs give the liberty to invest a definite sum of money at regular intervals in a mutual fund scheme. With each instalment, the investor purchases units of the mutual fund. The redemption of SIP is on a FIFO basis i.e., first in, first out. 

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Short-term capital gains from SIPs in equity funds are taxable @ 15% with no threshold limit. In contrast, long-term capital gains from SIPs are exempted from taxes up to Rs 1 lakh, and the excess gains are taxable @ 10% during a financial year.

A snapshot

Equity-oriented funds

  • Short term capital gain: 15% + 4% cess = 15.6%
  • Long term capital gain: 10% + 4% cess = 10.4% (if the income exceeds 1,00,000) 

Debt funds: 

  • Short-term capital gain: added to the assessee’s taxable income. 
  • Long term capital gain: 20% + 4% cess = 20.8%

Hybrid equity-oriented funds: 

  • Same as equity-oriented funds

Hybrid debt funds: 

There is no denying that there are significant tax implications on mutual funds, and you are likely to be parted with a portion of your gains on mutual funds. Still, this doesn’t diminish the viability of mutual funds as an investment avenue with potential for returns over time. Assess the tax implication of the mutual fund on your overall portfolio before investing in mutual funds.

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