Taxation On Mutual Funds & How To Earn Returns In It

6 mins read
by Angel One
Mutual funds attract taxation on dividends earned on the scheme and capital gains. Taxation on mutual funds depends on the type of the fund, income distribution, holding period, and capital gains.

Introduction

Taxation on mutual funds depends on multiple factors such as the type of mutual funds that you would invest in (equity, debt, or hybrid), the mutual fund income (dividend income or capital gains), the income slab you belong to, and the duration (long or short-term). While you try to gauge multiple factors while investing in mutual funds, one that is equally important to consider just as other factors is the taxation on mutual funds. 

What is the tax on mutual funds?

Along with knowing more about the taxation on mutual fund investment, it is important to know about the growth and the dividend plan. As mutual funds are not excluded from market risks and volatilities, the fund value may show appreciation or depreciation daily.  Despite these fluctuations, mutual funds are more likely to perform well in the long term. The gains made in the short term are distributed to the investors as a dividend. This dividend is proportional to the units of the mutual fund scheme held by the investors.  When the units are redeemed, the total fund value along with the invested value and the returns are collectively known as the investor's capital gains. This leads the mutual funds to be categorised in two ways: when the investors take the regular dividend payout in the dividend plan, and the other one is the growth plan when the dividends are reinvested.

Factors impacting tax on mutual funds in India

Here are the four factors that determine taxation on mutual fund investment in India:
  1. Type of funds - Taxes are applied to mutual funds based on the type of funds. These funds are equity funds and non-equity funds.
  2. Income distribution - When the NAV (Net Asset Value) units are sold at a higher price than the purchase price, the obtained gains are credited to an Equalisation Reserve Account. Income distribution or capital withdrawal payouts are done at the discretion of its trustees. The amount that the investors receive is considered to be income from other sources and is taxed in the hands of the investors.
  3. Holding period - In India, the holding period determines taxation. For example, a lower holding period calls for higher taxation and vice versa.
  4. Capital gains - Taxation on mutual funds is also based upon capital gains obtained from the appreciation that the investors earn after selling their assets at higher prices.

How Do You Earn Returns in Mutual Funds?

Investing in mutual funds allows the investor to earn gains through:
  • • Stock dividend income 
  • • Gains from bond interest
  • • Capital gains from securities
  • • When the value of a mutual fund scheme increases
Investors must highly consider these metrics before investing. 

Taxation of Dividends Offered by Mutual Funds

Since dividend is a profit, it attracts a tax called Dividend Distribution Tax (DDT). Earlier, dividends were taxable at source i.e. the scheme or the AMC was liable to pay DDT before distributing it to the unit holders. However, with effect from 1st April 2020, DDT has been abolished. Dividends earned on mutual funds are now taxable in the hands of investors. Income from dividend is taxable under the head income from other sources as per their individual tax slabs.

Taxation of Capital Gains of Equity Funds

  1. Short-term capital gains (STCG) - Investment in equity for less than 12 months is known as Short-Term Capital Gains. This attracts a short-term capital gains tax of 15%.
  2. Long-term capital gains (LTCG) - Gains from equity mutual funds that are held for more than 12 months are known as Long-Term Capital Gains. Capital gains for more than Rs. 1 lakh in a financial year are exempted from tax. An amount exceeding Rs. 1 lakh in a financial year attracts a tax of 10% without indexation.

Taxation of Capital Gains of Debt Funds

  1. STCG - As for debt funds, a holding period of fewer than 36 months is considered to be Short-Term Capital Gain. Taxes on the short term for debt funds are applicable as per the investor's income slab.
  2. LTCG - Debt fund gains obtained after holding investments for more than 36 months are taxed at 20% after the indexation benefits. Indexation refers to adjusting the gains as per the rate of inflation. The tax on debt funds can be higher without an indexation fund. 

Taxation of Capital Gains of Hybrid Fund

The taxation for a hybrid mutual fund investment depends on whether it is equity-focused or debt-focused. A hybrid fund with more than 65% equity exposure is an equity-focused scheme, while all other hybrid funds are debt focused. The taxation laws that apply to equity and debt funds also apply to hybrid mutual funds depending upon their equity exposure. 
  1. Equity-focused hybrid fund - LTCG for such funds is taxed at a rate of 10% without indexation, on gains that exceed Rs. 1,00,000 without indexation. Whereas, the Short-term Capital Gains are charged at 15%.
  2. Debt-focused hybrid fund - The Long-term Capital Gains are charged at a rate of 20% along with indexation benefits. The Short-term Capital Gains are charged as per the investor’s tax slab.

Taxation of Capital Gains When Invested Through SIPs

Mutual funds investments via SIP are considered individual investments. If the investor decides to redeem their investment within 12 months of SIP payments, their gains would not be tax-free. The gains earned in the first SIP will only be considered to be tax-free as only that investment will have been completed in 1 year. The rest of the capital will be counted as short-term gains taxes. 

Securities Transaction Tax (STT)

STT is levied on securities trade transactions listed on India’s registered stock exchanges. An investor is expected to pay STT, every time securities are bought and sold on the listed stock exchange. This can be in the form of shares, bonds, debentures, or equity-oriented mutual funds. The fund manager may charge you a Securities Transaction Tax (STT) of 0.001% if you want to sell your equity fund units. STT does not apply to the sale of units in debt mutual funds.
FAQs

Are there any tax implications for switching between mutual funds?

Yes. If the investor wishes to switch mutual fund schemes, they are obligated to pay taxes, as switching schemes is considered an act of redeeming the investments. Schemes can be switched by redeeming units and investing the amount in another scheme or by requesting the fund house to switch schemes.

Where can i finIs it possible to avoid capital gains tax?d tickets?

Although it is not possible to avoid capital gains tax, it is possible to save tax if you do tax planning in an efficient manner. For instance, Short-term Capital Gains on mutual funds are higher than Long-Term Capital Gains, which reduces the tax liability investments held for the long run.

Can I claim tax deductions on investments in mutual funds?

As per the Mutual Fund Tax Benefit under Section 80C (Income Tax Act, 1961), investments made under Equity Linked Savings Systems (ELSS) mutual funds call for deduction from the taxable income. The maximum amount eligible for a tax deduction is Rs. 1.5 lakhs per financial year.

Are mutual fund taxes payable every year?

No. You are only liable to pay taxes when you sell your holdings. However, the dividend income will be added to your taxable income. Hence, you will be liable to pay tax on your dividend income as per your income tax slab.