Tax Implications of Investing in Mutual Funds

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Mutual funds allow high levels of tax savings and hence are a preferred option for investment.

Tax Implications on Mutual Funds

Mutual funds are one of the most popular investment options since they help you achieve your financial goals. Mutual funds might also help you save money on taxes. Fixed deposits have a significant disadvantage, especially if you are in the highest income tax band since interest is added to your taxable income and taxed at the rate determined by your income tax slab.

What Is The Best Way To Make Money With Mutual Funds?

Mutual funds provide two forms of rewards: dividends and capital gains. Dividends are paid out of the company’s profits if any are available. Investors get dividends in proportion to the number of mutual fund units they possess.

The profit realized by investors when the selling price of the securities they hold exceeds the purchase price is known as a capital gain. In the hands of mutual fund investors, dividends and capital gains are equally taxable.

Taxation of Equity Funds’ Capital Gains

Mutual funds with a portfolio equity exposure of more than 65 percent are called equity funds. As noted previously, short-term capital gains are achieved when you surrender your equity fund units during a one-year time frame.

Taxation of Debt Funds’ Capital Gains

Debt funds are mutual funds that have more than 65 percent of their portfolio invested in debt. Short-term capital gains arise from redeeming your debt fund units after a three-year holding period. When you sell debt fund units after a three-year holding period, you receive long-term financial gains. These gains are taxed at a flat rate of 20% after indexation. You’ll also be charged the appropriate tax cess and fee.

Capital Gains Are Taxed When Investing Through SIPs

SIPs, or systematic investment plans, are a kind of mutual fund investing. You won’t have to pay any tax if your long-term capital gains are less than Rs 1 lakh. However, you begin to get short-term financial gains on units acquired via SIPs after the second month.

ELSS Tax Implications

ELSS is a great way for retail investors (individual investors) to minimize taxes while also potentially earning inflation-beating returns over time. ELSS is a tax-saving tool that is eligible for the Income Tax Act, 1961’s Section 80C taxation benefit of up to Rs 1.5 lakh per year. It has the lowest lock-in term of any Section 80C options, at only three years.

Furthermore, among tax-saving investments, ELSS has the potential to provide the best returns over time. You might use a structured investment plan, or SIP, to invest in ELSS. It enables you to invest specified sums of money in the ELSS on a regular basis. Through the SIP, you may invest as little as Rs 500 every instalment in the ELSS.

When it comes to ELSS schemes, there are two types – dividend and growth schemes. Dividend schemes allow investors to earn an extra income from dividend payments as and when the fund house declares to distribute the surplus. On the other hand, the growth funds are best suited for long-term wealth creation through capital appreciation. The dividend you earn from your investment is exempted from tax. Also, there is no lock-in. Investors can withdraw bonuses anytime or reinvest and continue to enjoy tax benefits. Growth funds, however, don’t offer such benefits under ELSS.

Comparison between ELSS, PPF, and FD

Here is a chart comparing the three popular investment options.

Parameters ELSS PPF FD
Eligibility Any Indian individuals, including NRIs, who pay tax. Available only to residential Indians. Tax paying individuals, NRIs, and HUF
Investment Amount Minimum investment threshold is Rs 500. And one can invest upto any amount. Rs.500 up to Rs.1.5 lakh Rs.100 to up to Rs.1.5 lakh
Lock-in-Period 3 years The minimum investment period should be 15 years The minimum investment period is 5 years. There is often a penalty on early withdrawal.
Tax on Returns Tax-free Tax-free Taxable
Expected Returns 10% to 15% , depending on market conditions No Return No Return
Investment period Medium to Long Term Long Term Medium to Long Term
Loan Facility Investors are eligible for a partial loan after three-years lock n Loan facility available after the completion of 3 years No loan available
Risk Subject to market risks Risk-free Risk-free
Tax Benefits Up to Rs.1.5 lakh as specified u/s 80C of Income Tax Act, 1961 Rs.1.5 lakh u/s 80C of Income Tax Act, 1961 Rs.1.5 lakh u/s 80C of Income Tax Act, 1961

Characteristics of tax saving mutual funds

  • You can start investing with a small amount. The minimum investment for equity-linked mutual funds is Rs 500. And, unlike PPF and NSC, there is no upper limit on ELSS investment.
  • While there is no upper investment limit, tax exemption is available only up to Rs 1.5 lakh.
  • You can also invest through SIP, which allows the advantage of compounding and rupee cost averaging.
  • These funds, however, will come with a three-year lock-in period. If you are investing through SIP, the lock-in will be calculated separately for each instalment.
  • These are equity-linked products, meaning the returns depend on market fluctuations, which can be more, moderate, or less depending on the market condition at the time of redemption.
  • Typically, ELSS schemes are open-ended.
  • Usually, these funds allow investors to nominate a nominee for the scheme.
  • These funds come with entry and exit loads, fees typically charged by the fund company for handling your investment.
  • When it comes to listing the benefits of these funds, there are quite a few. Here they are.
  • Investors in these schemes can claim tax benefits of up to Rs 1.5 lakh.
  • The long term gain from ELSS investment is tax exempted.
  • Investors can use tax saving mutual fund investment to meet future financial goals like buying cars or paying for children’s education.
  • These funds allow investors to invest through SIP. Therefore, even small investors can invest as there is no need to invest in a lump sum.
  • The corpus is invested across industries and sectors to reduce the concentration of funds in any particular investment and thus, reduces investment risk to a great extent.
  • Investors can withdraw the dividend earned, and there is no tax calculated on it. However, you can also decide to reinvest.
  • While other tax-saving investments come with extended lock-in periods, it is only three years for ELSS funds.
  • These funds are primarily open-ended, meaning one can invest year-round.
  • These are actively managed funds handled by skilled fund managers. Hence, investors with little or no knowledge of the market can also invest.

Wrapping Up

Your tax payment will be reduced if you maintain your mutual fund units for a longer period of time. The tax rate on long-term capital gains is lower than that on short-term capital gains.

Frequently Asked Questions (FAQs)

What is the tax rate on mutual fund withdrawals?

If you sell your stock mutual fund units after 12 months, you will have made a long-term financial gain. Without the advantage of indexation, long-term capital gains will be taxed at 10%. A long-term capital gain on equities mutual funds of up to Rs 1 lakh is also tax-free.

What is the best tax-free mutual fund?

Within the Rs 1.5 lakh limit, ELSS funds are the only tax-saving funds with the added benefit of providing equity-linked returns. Investing in an ELSS provides you with both financial appreciation and tax savings.

Is a mutual fund SIP tax-free?

Every SIP payment into a SIP qualifies for Section 80C tax deductions. You may get a tax refund of up to Rs 1,50,000 and save up to Rs 46,800 in taxes every year.