Mutual Fund Taxation: A Comprehensive Overview
Mutual funds are among the most popular investment choices because they enable you to reach your financial objectives. Additionally, mutual funds are tax-efficient investments. Because interest is added to your taxable income and taxed at your income tax slab rate, investing in fixed deposits is very disadvantageous, especially if you are in the highest income tax bracket. Mutual funds perform better in this area. Investing in a mutual fund offers you the advantages of tax-efficient returns and professional money management. In this article, we will share the essential aspects of mutual fund taxation.
Table of Contents
What is Tax on Mutual Funds?
Profits from mutual fund investments are known as "capital gains." Taxes apply to these capital gains. Therefore, you should know how your returns are taxed before investing in mutual funds. Additionally, in some circumstances, you may be eligible for tax deductions. When calculating long-term capital gains on debt mutual funds—that is, mutual funds that allocate less than 35% of their corpus to stocks or equity-related instruments—no indexation benefit will be accessible. Mutual funds with debt are taxed according to the applicable slab rates for the investor. Investments in debt funds made after April 1, 2023, are the only ones eligible.
Factors that Determine Tax on Mutual Funds
Identifying the factors that influence mutual fund taxation will help to clarify it further. The primary factors influencing the taxes levied on mutual funds are as follows:
Fund types: The tax regulations vary according to the mutual fund type. For instance, hybrid mutual funds, debt mutual funds, and equity mutual funds.
Dividend: A portion of the profit that mutual fund companies distribute to investors is known as a dividend.
Capital gains: The profit by investors when they sell their capital assets for more than the entire amount they invested is known as capital gains.
Holding period: The time between the mutual fund units' purchase and sale dates. According to Indian income tax laws, you will only have to pay a small amount in taxes if you keep your investment for a long time. The holding period impacts the tax rate you must pay on your capital gains. Your tax liability decreases as your holding period increases.
Returns in Mutual Funds: How Do Mutual Funds Generate Income
Capital gains and dividends are the two types of returns that mutual funds provide. Dividends are distributed from the company's profits if any exist. Businesses may choose to distribute their excess cash to investors as dividends when they have it. Dividends paid to investors are based on how many units of mutual funds they own. The profit investors realise when the selling price of the security they own exceeds the purchase price is known as a capital gain. Simply put, the appreciation in the price of the mutual fund units results in the realisation of capital gains. Investors in mutual funds are subject to taxes on both dividends and capital gains.
Taxation of Mutual Funds Dividends
According to the Union Budget 2020 amendments, dividends paid by any mutual fund scheme are subject to regular income taxation. In other words, investors' dividends are taxed at the rates of their individual income tax slabs after being added to their taxable income.
In the past, investors received dividends tax-free because companies paid dividend distribution tax (DDT) before disbursing dividends.
Taxation of Mutual Funds Capital Gains
The type of mutual fund and the time it is owned determine the capital gains tax rate. The following categories apply to capital gains realized when selling mutual fund units:
Fund Type | Short-term capital gains | Long-term capital gains |
Equity funds | Shorter than 12 months | 12 months and more |
Debt funds | Always short-term | |
Hybrid equity-oriented funds | Shorter than 12 months | 12 months and more |
Hybrid debt-oriented funds | Always short-term |
Taxation of Mutual Funds
Mutual funds have different tax rates for their short-term and long-term capital gains. The duration of holding determines how mutual funds are taxed. Regardless of the holding time, debt mutual funds—that is, mutual funds that invest less than 35% of their profits in domestic companies' equity shares—will be regarded as short-term. Note that this only applies if the debt mutual funds are bought after March 31, 2023. You will gain a better understanding from the following table.
Type of Mutual Funds | Tax rates(Funds bought before 31 March 2023) | Tax Rates(Funds bought after 31 March 2023) | |||
Holding Period | STCG | LTCG | STCG | LTCG | |
Equity Mutual Fund Arbitrage Funds Other Funds (invests at least 65%in equity) | 12 months | 15% | 10% without indexation | 15% | 10% without indexation |
Debt Mutual Fund (Debt securities, government securities, money market instruments, corporate bonds) Floater Funds (Minimum 65% invested in floating rate instruments) | 36 months | Slab rate | 20% with indexation | Slab rate | Slab rate |
Conservative Hybrid Funds (Equity: 10%-25%/ Debt: 75%-90%) Other funds (which invest 35% or less in equity) | 36 months | Slab rate | 20% with indexation | Slab rate | Slab rate |
Other funds (invest more than 35% but less than 65% in equity) | 36 months | Slab rate | 20% with indexation | Slab rate | 20% with indexation |
Balanced Hybrid Funds (Equity: 40%-60%/ Debt: 60%-40%) | 36 months | Slab rate | 20% with indexation | Slab rate | 20% with indexation |
Aggressive Hybrid Funds (Equity: 65%-80%/ Debt: 35%-20%) | 12 months | 15% | 10% without indexation | 15% | 10% without indexation |
For listed equity shares, an equity-oriented fund unit, and a business trust unit, the short-term capital gain tax rate has been raised from 15% to 20%. Slab tax rates will continue to apply to other short-term financial and non-financial assets.
When transferring equity shares, equity-oriented units, or business trust units, the annual exemption from long-term capital gains has been raised from Rs. 1 lakh to Rs. 1.25 lakh. However, it is now taxed at a rate of 12.5% instead of 10%.
On July 23, 2024, the tax rate was altered, however, the exemption ceiling was raised to Rs. 1.25 lakhs for the entire year.
Additionally, after July 23, 2024, the indexation benefit will no longer be accessible.
Taxation of Debt Funds Capital Gains
Mutual funds having more than 65% of their portfolio in debt and less than 35% in equity are known as debt funds. The debt funds will no longer be eligible for indexation benefits and will be considered short-term capital gains as of April 1, 2023. As a result, your taxable income will now include the gains from debt funds, which will be subject to slab-rate taxation. Long-term capital gains from debt funds were previously subject to 20% taxation with an indexation benefit.
Taxation of Equity Funds Capital Gains
Mutual funds classified as equity funds have more than 65% of their total value invested in company equity shares. Redeeming your equity fund units within a year results in short-term capital gains. The 15% flat tax rate applies to these gains regardless of your income tax bracket. After holding your equity fund units for years, you sell them and realise long-term capital gains. These capital gains are exempt from taxes up to Rs 1 lakh annually. LTCG tax at 10%, without indexation benefit, is applied to any long-term capital gains that surpass this threshold.
Taxation of Debt Funds Hybrid Gains
The taxability of capital gains on hybrid or balanced funds depends on the proportion of equity. The fund scheme is taxed like an equity fund if the equity exposure is higher than 65%; otherwise, the debt fund taxation rules are applicable. As a result, it is crucial to understand the hybrid scheme's equity exposure; otherwise, you risk receiving a nasty surprise when your fund units are redeemed. The capital gains tax rate on mutual funds is presented in the table:
Fund type | Short-term capital gains | Long-term capital gains |
| 15% + cess + surcharge | Any gains above Rs 1 lakh taxed at 10% + cess + surcharge |
| Income tax slab rate applicable to the investor | Income tax slab rate applicable to the investor |
Taxation of Capital Gains on SIPs
Systematic investment plans are a method of investing in mutual funds. The structure enables investors to make recurring investments in mutual fund schemes. Investors have the freedom to decide how frequently they want to make investments. Weekly, monthly, quarterly, bi-annual, or annual are all possible. A specific number of mutual fund units are acquired with each SIP instalment. There is a first-in, first-out process for redeeming these units.
Suppose you withdraw all your money from an equity fund after 13 months of investing in it through a systematic investment plan (SIP) for a year. In this instance, you realise long-term capital gains on the units you initially bought through the SIP, which are held for a long time (more than a year). You are exempt from paying taxes if your long-term capital gains are less than Rs 1 lakh. However, starting in the second month, you realise short-term capital gains on the units you bought using the SIPs. Regardless of your income tax slab, these gains are subject to a flat 15% tax rate. It will be subject to the applicable cess and surcharge, which you must pay.
Securities Transaction Tax (STT)
The Securities Transaction Tax (STT) is additional in addition to the capital gains and dividend taxes. When you buy or sell mutual fund units of an equity fund or a hybrid equity-oriented fund, the Ministry of Finance levies a 0.001% STT. The sale of debt fund units is exempt from STT.
Declaring Mutual Fund Investments in ITR
The guidelines for disclosing mutual fund income in an ITR are listed below:
Dividend Income: Dividends are regarded as the investor's income and are added to his total income under the heading "income from other sources," regardless of whether they come from debt or equity mutual funds. A salaried person may report this type of income under "Income from other sources" on their ITR-1.
Income From Sale: The taxation and disclosure of any income derived from the sale of mutual funds are contingent upon the mutual fund's characteristics and duration of holding.
Gains in capital over the short-term
Debt mutual funds: Units of a debt mutual fund that are sold or redeemed within 36 months of purchase result in short-term capital gains. These gains are included in the investor's overall income and subject to the appropriate taxation.
Equity Mutual Funds: Equity mutual funds are subject to 15% tax if sold within a year of the purchase date and are deemed short-term capital gains.
Long-Term Profits
Debt mutual funds: Long-term capital gains are defined as debt funds sold or redeemed for over 36 months. Following indexation, these gains are subject to 20% taxation.
Equity Mutual Funds: Long-term capital gains are profits from the sale of equity mutual funds purchased within a year. These gains are tax-exempt up to ₹1,00,000; the rest is subject to 10% tax.
Conclusion
In conclusion, investors worried that their mutual fund returns will be diminished after paying taxes can find out how mutual funds are taxed. By figuring out how the tax laws for short- and long-term investments in debt and equity funds vary, they can ascertain what is best for them. They can create a corpus and lessen their tax responsibilities by investing in tax-saver funds. A fund's taxation is the same whether bought in one go or through a systematic investment plan, SIP. Nonetheless, holding the units for a short time may not be as tax-efficient as long-term investments.
FAQ
Q1. Are mutual fund taxes payable every year?
You only have to pay the relevant taxes when you sell the mutual fund or redeem the units if you choose to use one. It is not a yearly occurrence. However, include your dividend income from mutual fund schemes in your total revenue for the relevant fiscal year. For this dividend income, you must pay taxes if your income is subject to income tax.
Q2. Can mutual fund investments enable investors to get a rebate on income tax?
The Income Tax Act's Section 80C provides tax benefits to Equity Linked Saving Plans or ELSS. You can save about Rs. 46,800 annually on taxes and receive a tax deduction of up to Rs. 1.5 lakh. The minimum lock-in period for ELSS is three years.
Q3. Are wealth taxes applicable to MF investments?
The Wealth Tax Act states that financial assets such as mutual funds are not subject to wealth taxes. Therefore, when you invest in a mutual fund, you are exempt from paying wealth tax.
Q4. What is Section 54EA regarding exemptions to capital gains tax?
A long-term capital asset transferred before April 1, 2000, is exempt from capital gains calculations under Section 54F if invested in specific bond shares within six months of the transfer date, as per Section 54EA.
Q5. What are tax-saving mutual funds?
Tax-saving mutual funds, or ELSS can help you receive a deduction under Section 80C of the Income Tax Act.
Q6. What are the factors to consider before choosing tax-saving mutual funds?
Even though tax-saving mutual funds have drawbacks, there are four things you should look for when choosing one. These include the lock-in period, asset allocation, tax exemption limits, and investment mode.
Q7. Is it possible to avoid capital gains tax?
No, you cannot avoid paying capital gains taxes; however, you can make your investment more tax-efficient by planning it appropriately. For example, short-term capital gains are subject to higher taxes than long-term ones. Therefore, you must know the various taxes imposed on mutual fund schemes.
Q8. Are mutual funds tax-free?
Like gains and profits from most other asset classes, mutual fund gains and profits are subject to taxes. Since taxes are hard to avoid, it will be helpful to understand the mutual fund tax regulations before investing.
Q9. What is the tax on SIP after 20 years?
SIP investments held for 20 years are considered long-term capital gains (LTCG). Tax exemptions apply to gains up to Rs. 1 lakh per fiscal year. Gains over this threshold are subject to 12.5% taxation without the indexation benefit.
Q10. What is the long-term capital gain on mutual funds?
After holding your equity fund units for years, you sell them and realise long-term capital gains. These capital gains are exempt from taxes up to Rs 1 lakh annually. Any long-term capital gains over this threshold are subject to a 10% LTCG tax without the benefit of indexation.
Q11. Under which section is the income from mutual fund exempt?
Mutual funds are not tax-free except for certain retirement funds and equity-linked savings schemes, also known as tax-saving funds. According to Section 80C of the Income Tax Act, you can save up to Rs. 46,800 in taxes and claim a deduction of up to Rs. 1.5 lakh for investments made in ELSS.
Q12. What is the tax on mutual fund withdrawal?
Short-term capital gains (STCG) are gains from equity fund units held for a maximum of one year (12 months) before redemption and taxed at a rate of 20%. The Long Term Capital Gains (LTCG) tax is applied if held for over a year. For equity mutual funds, the LTCG tax rate is 12.5% on gains over Rs. 1.25 lakh per year.
Q13. What is the tax on mutual fund profit?
Gains from listed equity shares and equity-oriented mutual funds that surpass ₹1 lakh are subject to a 10% tax. LTCG from other assets is subject to individual income tax slab rates.
Q14. Which ITR has to be filed for capital gains on mutual funds?
You must report any capital resulting from the sale of either short-term or long-term mutual funds on your ITR-2.
Q15. Under which section of the IT Act is mutual funds income taxed?
The holding period of the mutual fund units determines which section the income from the mutual fund is taxed under. Long-term capital gains are subject to section 112A taxation, whereas short-term capital gains are subject to section 111A taxation.
Q16. Are capital gains on Mutual funds subject to TDS?
Dividend income from mutual funds is subject to TDS deductions. Dividend income over Rs. 5000 is subject to 10% TDS. TDS does not apply to any capital gains made from mutual fund units.
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