Mutual Fund Taxation: Overview of Tax Implications of Investing in MF

Mutual funds have emerged as one of the most popular investment avenues for investors in India. As per the data released by the Association of Mutual Funds in India (AMFI), the Indian MF industry's Average Assets Under Management (AAUM) stood at ₹52.74 lakh crore as of January 2024. The high popularity of mutual funds can be attributed to the professional management of pooled money from numerous investors, portfolio diversification, high liquidity, transparency, flexibility, affordability and regulations.

However, one important aspect that often goes unnoticed is taxation. Taxation plays a crucial role in determining your overall returns from mutual funds. Therefore, as an investor, you need clarity on how your mutual fund investments will be taxed. 

So let's get started.

How Do You Earn Returns from Mutual Funds?

The tax implications of mutual funds depend on the type of earnings from that mutual fund. There are two ways by which investors can earn returns from their mutual fund investments:

1. Dividends 
2. Capital Gains

Dividends

Dividends represent that portion of a mutual fund’s net earnings that the fund house declares to be distributed among unit holders. You receive the dividend amount based on the number of units you hold in that mutual fund scheme. 

Companies announce dividends only when they have surplus cash left after business operations to share with investors. Similarly, fund houses pay dividends either from the capital gains they earn by selling securities or stocks or from interest earned in the case of debt funds.

Capital Gains  

Capital gains refer to the profit earned when investors redeem or sell their mutual fund units at a higher price than their purchase price. The returns generated this way are called Capital Gains. In simple words, the appreciation in the net asset value (NAV) per unit of the mutual fund scheme leads to capital gains for investors when they redeem the units.

Both dividends and capital gains form taxable income in the hands of mutual fund investors as per Indian income tax laws. Now, let's understand how dividends and capital gains offered by mutual funds are taxed.

Taxation of Dividends from Mutual Funds

The Union Budget 2020 brought in an amendment whereby dividends distributed by companies, as well as mutual funds, are taxed under the classical system of taxation. 

Earlier, companies had to pay Dividend Distribution Tax (DDT) at 15% plus applicable surcharge & cess before distributing dividends to shareholders. This concept of DDT has now been abolished.

As per the amended taxation system, any dividend income from mutual funds received by an investor has to be included in his/her taxable income for that year. This dividend income will then be taxed as per the investor's applicable Income Tax slab rate.

Therefore, dividend payment by mutual funds is not tax-free anymore in the hands of the investor. The dividend amount gets added to your taxable income for that financial year, and you need to pay tax at the income tax slab rate applicable to you.

The removal of DDT has been a blessing for investors falling under lower-income tax brackets. However, it has proved harsh for investors under higher tax slabs of 30% and above. Let's understand this with the help of an example:

Suppose Ms Sejal, aged 30 years, invests ₹ 5 lakhs in an equity mutual fund. The fund declares a dividend of ₹50,000 during the financial year. Sejal falls under the highest income tax slab rate of 30%. Here is how her tax liability will be calculated:

Particulars	Amount (₹)
Dividend Income	50,000
Add: Dividend Income Taxable at Slab Rate of 30%	50,000
Income Tax @30% on Dividend Income	15,000

Therefore, though the dividend amount was ₹ 50,000, Sejal had to pay an income tax of ₹15,000 on this, implying an effective tax rate of 30% on the dividend.

So, in a nutshell, dividends from mutual funds are now taxable in the hands of the investor as per the applicable slab rates.

Taxation of Capital Gains Offered by Mutual Funds 

As an investor, the maximum returns from your mutual fund investments come in the form of capital gains. Hence, you must understand the taxation of these capital gains thoroughly. 

The holding period of the mutual fund units and the type of mutual fund scheme plays a vital role here:  

Based on the Holding Period  

1. Short-Term Capital Gains (STCG): When mutual fund units are sold within a short period, the investor realises Short-Term Capital Gains. The holding period to be categorised as STCG may differ across fund types.
2. Long-Term Capital Gains (LTCG): If mutual fund units are held for an extended period before selling, it results in Long Term Capital Gains for investors. Here, the minimum holding period may also vary depending on the fund. 

The rates of taxation also differ in the case of STCG and LTCG. Generally, LTCG tax rates are lower compared to STCG tax rates.

Based on Type of Scheme

There are 3 major categories of mutual fund schemes: 

1. Equity Funds: Primarily invest in equity stocks of various companies. A minimum of 65% of the fund corpus should be invested in equities.  
2. Debt Funds: Majorly invest in fixed-income securities like corporate bonds, government securities, money market instruments, etc. At least 65% exposure towards such securities.
3. Hybrid Funds: Invest across both equities and debt. Equity exposure is generally 40-60% or 65-80% in the case of hybrid funds.

Now, let us look at the taxation of capital gains on each fund type.

Taxation of Capital Gains of Equity Mutual Funds 

1. Short-Term Capital Gains: When equity mutual fund units are sold within 1 year from the purchase date.
2. Long-Term Capital Gains: When equity mutual fund units are sold after 1 year from the purchase date.

Tax Rates on Equity Fund Capital Gains:   

Period of Holding	Tax Rates
Short-Term Capital Gains	Units sold within 1 year, 15%
Long-Term Capital Gains	Units sold after 1 year, 10% (Only on gains above ₹1 Lakh per year)

Highlights

• STCG is taxed at a flat 15%, irrespective of the investor's tax slab 
• LTCG up to ₹1 lakh per year is fully exempt from tax 
• LTCG above ₹1 lakh is taxed at 10% without indexation benefit

Therefore, equity funds attract comparatively lower LTCG tax compared to other asset classes. This makes long-term investment in equity funds highly tax-efficient.

Taxation of Capital Gains of Debt Mutual Funds  

With effect from 1 April 2023, debt funds shall be treated as short-term capital gains only, irrespective of the holding period. 

The withdrawal of the indexation benefit implies that the gains shall now be added to the investor's taxable income for the year and taxed as per the applicable slab rate. 

Earlier, debt funds attracted LTCG tax at a flat 20% with indexation after three years. But now, the LTCG tax at 20% stands abolished, and all capital gains from debt funds shall be taxed as short-term capital gains.

Tax Rates on Debt Fund Capital Gains:   

Period of Holding	Tax Rates
Short-Term Capital Gains	Units sold before or after 3 years, At the investor's applicable Income Tax slab rate
Long-Term Capital Gains	There is no separate LTCG tax rate. Clubbed with STCG

Highlights

• STCG is to be added to the investor's total taxable income for the year
• Tax to be paid as per investor's applicable slab rate  
• No separate LTCG tax; now clubbed with STCG

This proposed change shall reduce the tax efficiency of investing in debt funds for investors falling under higher tax brackets.

Taxation of Capital Gains of Hybrid Mutual Funds

Hybrid mutual funds invest across equity and debt asset classes within a single scheme. Based on the equity exposure, they are further classified into:

1. Equity-oriented Hybrid Funds: At least 65% exposure to equity. The equity-oriented hybrid funds are taxed similarly to equity funds. The units must be held for over a year to qualify for LTCG.
2. Conservative Hybrid Funds: 10-25% equity & 75-90% debt exposure. Conservative hybrid funds and other funds having less than 65% equity exposure are taxed like debt funds. All capital gains are now considered STCG and taxed per the investor's slab.     

Taxation of Mutual Funds When Invested Through SIPs  

Many investors prefer investing in mutual funds through Systematic Investment Plans or SIPs. SIPs allow you to invest small fixed amounts periodically, like monthly, quarterly, etc., towards your targeted mutual fund scheme.

When units are redeemed from a mutual fund where investments have been made via SIP, the calculation of short-term & long-term capital gains happens based on first-in-first-out (FIFO).

This implies units purchased first or earlier are considered to be redeemed first at the time of redemption. The holding period is calculated for each set of units bought from the respective SIP instalment dates.  

Let us understand this with an example. 

In January 2023, Rahul started a monthly SIP of ₹5,000 in an equity fund, planning to invest for 15 months.

• He will purchase some units in January 2023 through his 1st SIP instalment
• In February 2023, a few more units will be purchased via the next SIP 
• Likewise, every month, new units are added to his kitty through each SIP

Now, Rahul has decided to redeem ₹ 50,000 worth of units after 18 months from the 1st SIP date.

Here, the units purchased in the first three monthly instalments qualify as long-term (held for over one year). Hence, LTCG shall apply this to their sale value. 

On the other hand, units bought from the 4th SIP instalment qualify as STCG since their holding period is less than one year.

When investments happen through SIP, the capital gains taxation can become slightly complex. However, the internationally accepted FIFO method simplifies the calculations.

Securities Transaction Tax (STT) 

Apart from taxes on capital gains and dividends, mutual fund investors also need to pay Securities Transaction Tax (STT) on equity funds and equity-oriented hybrid fund transactions.

• An STT of 0.001% applies to the unit purchase or sale value when investors buy or sell mutual fund units. 
• STT is not payable for transactions (purchase/redemption) in non-equity mutual fund schemes like debt or gold funds.

The concept of STT was introduced to reduce the burden of capital gains tax and provide impetus to the stock markets. Though the STT rate is very minimal currently, it adds up to the overall costs for active mutual fund investors.

How To Invest in Mutual Funds on Angel One?

1. Open the Angel One app. On the Home page, go to ‘Mutual Funds’.
2. Choose the Mutual Fund that you want to invest in from the various lists provided on the Mutual Fund portal.
3. Choose whether you want to invest via lump sum or SIP mode.
4. Enter the amount that you want to invest.
5. Click on the payment button to complete the payment and start your investment.

Conclusion  

We hope this detailed guide on all the critical taxation aspects covers your queries on mutual fund taxation. Remember, taxation should not be the sole criterion while investing in mutual funds. Factors like asset allocation, past performance, expense ratio, fund management team, etc., play an equally important role in deciding the suitable funds for your portfolio.

To conclude, the key takeaways from this article are:

• Dividends from mutual funds are now taxable as per the investor's income tax slab rates 
• Holding period of units plays a vital role in deciding capital gains tax  
• Long-term capital gains enjoy favourable tax treatment across all fund types
• Maintain the right asset allocation and do proper due diligence before picking schemes 
• Do not let tax be the sole driving factor for your MF investments

Invest prudently, keeping the taxation angle in mind and grow your wealth steadily over the long term!

With that said, even now there are a few questions that are frequently asked by mutual fund investors, so let us quickly run through some of them. 

Frequently Asked Questions on Returns on Mutual Fund

1. Are mutual fund taxes payable every year?

No, mutual fund taxes are not payable yearly. Tax is applicable only when investors redeem or sell mutual fund units at a gain, thereby realising capital gains OR if they receive any dividend from the funds. The dividend income needs to be reported in annual tax returns.

2. Is it possible to avoid capital gains tax?  

It is not legally possible to fully avoid capital gains tax. However, long-term capital gains enjoy favourable tax treatment - 10% in equity funds without indexation and exemption up to ₹1 lakh per year. You can plan your redemptions carefully after one year to optimise taxes.

3. What are the factors to consider before choosing tax-saving mutual funds?

Besides high equity exposure and lock-in advantage, consider aspects like past returns compared to category average & benchmark, portfolio concentration, expense ratio, fund manager performance across market cycles, etc., before selecting Equity Linked Saving Schemes (ELSS).     

4. Can mutual fund investments help me claim tax deductions?

Investing in Equity Linked Saving Schemes (ELSS) helps claim a tax deduction u/s 80C of up to ₹1.50 lakh in a financial year. One can thus save around ₹. 46,800 in taxes annually by investing in ELSS mutual funds. Do note that ELSS investments have a lock-in of 3 years.  

5. Are wealth taxes applicable to mutual fund investments in India?

No, mutual funds & other financial assets are exempted from the purview of Wealth Tax in India. So, wealth tax does not apply to investments made in mutual funds.

In the upcoming chapters, let us dive into the different types of mutual funds, and ETFs and learn the scheme information document (SID).