How Mutual Funds are Taxed

Unlike fixed return schemes with a maturity period where the interests received get added to the annual income and become taxable in case your net annual income falls under a tax bracket, you can manage mutual funds returns effectively and increase your returns by saving taxes. Before learning further about tax on mutual funds, it is important to know what are the different types of returns that an investor earns from mutual funds.

Types of Returns On Mutual Funds

Mutual funds returns are generally of two types - Earnings from Dividends and Capital Gains. Subsequently, mutual fund taxation is also based on the type of return, i.e. the tax provisions for dividend earnings are different from that of capital gains. 

• Dividends are paid by companies in which your funds have been invested by the fund scheme. The dividends are paid when the company earns profits and decides to pay out some part of it to the shareholders. As a mutual fund investor, you will receive dividends as per the proportion to the mutual fund units you are holding. 
• A capital gain, on the other hand, is the return earned by selling mutual fund units at a price higher than the purchase price. For example, if you have purchased 100 units of a mutual fund for Rs 2,000, now the same 100 units are selling at Rs 2,200, your total capital gain after selling the units will be Rs 200. Capital gains are further classified into two types- short term capital gains (STCG) and long term capital gains (LTCG). Hence the taxation on mutual funds is also classified as - STCG in Mutual Fund and LTCG in Mutual Fund.

Taxation on Dividends Received From Mutual Funds

Before 2020, the dividends received by investors from investments in mutual funds (or equities) were not taxable as the dividend issuing company had to pay Dividend Distribution Tax (DDT) before extending dividends to the mutual fund investors or shareholders. However, the amendments proposed in the Union Budget 2020 changed the provision by exempting dividend issuing companies from paying DDT and making dividend receiving shareholders liable to pay taxes as per the laid provisions and rules. The dividends earned from the investments in mutual funds are now considered as ‘income from other sources’ and the same is taxed as per the tax slab based on net annual income. 

• The existing rules prescribe mutual funds to pay the DDT on the declared dividends. Equity oriented mutual fund schemes (with more than 65% asset invested in equities) are liable to pay 10% DDT, surcharge, and cess, which altogether makes the effective DDT 11.648%.
   
• On non-equity focused mutual fund schemes, the DDT is 25%, along with a surcharge and cess, resulting in a DDT of 29.12%.

Taxation on Capital Gains from Mutual Funds

As said, capital gains are broadly classified into STCG and LTCG, and hence, the taxation also varies accordingly. Furthermore, the short-term and long-term definitions for each type of mutual fund are also different.

• Equity funds,

Short-term- Less than 12 months

Long-term- Equal to or more than 12 months

• Debt funds,

Short-term- Less than 36 months

Long-term- Equal to or more than 36 months

LTCG on Mutual Funds

Mutual fund tax benefits are mainly realized on long term capital gains (LTCG).

Besides the ELSS schemes, LIC, School fees of children, and PF also qualify for the exemption.

STCG on Mutual Funds

STCG tax on mutual fund redemption in different schemes are as follows:

As we can see, LTCG is more advantageous than STCG in terms of taxation. Hybrid Funds who are equity oriented are taxed as Equity Funds and Debt oriented are taxed as Debt Funds.

Taxation on Capital Gains from Investments made through SIPs

SIPs allow you to invest a small amount every month in a mutual fund scheme. They give you the flexibility of investment and offer to earn more returns from the power of compounding. With every SIP installment, you are allotted certain mutual fund units. The period of capital gain is decided accordingly. 

• For example, if you have invested every month for a period of 12 months, and want to redeem all the units in the 13th month, the profits earned from selling the units allocated in the first month qualify for LTCG while the gains made from selling units allocated in the next 11 months are considered to be STCG.
• Additionally, if the gain is up to Rs 1 lakh, you do not have to pay any tax. Whereas, gains of above Rs 1 lakh are taxed at 15% irrespective of the net annual income tax slab of the investor.

Additional Taxes

Apart from taxes on LTCG and STCG, investors have to pay an additional tax of 0.001% called the Securities Transaction Tax (STT) on buying and selling of mutual fund units. However, the STT is levied only on equity mutual funds, and hybrid-oriented mutual funds, and not on debt funds.

Overall, it can be concluded that holding mutual fund investments for the long term is more beneficial as they give you tax-efficient returns. The capital gains made from long term investments are taxed less than short term capital gains. Moreover, making long-term investments is also considered to be healthy as they generate higher returns. You can earn more profits from compounding, and pay fewer taxes from your long term investments.

Key Takeaways

• Understanding the taxation aspects of Mutual Funds is essential before investing, as it affects overall returns and enables tax-efficient investment planning.
• Mutual Funds are subject to two types of taxes: Short-term Capital Gains Tax (STCG) and Long-term Capital Gains Tax (LTCG).
• Equity and Debt Mutual Funds have different tax rates for STCG and LTCG.
• Short-term Capital Gains Tax (STCG) on Equity Mutual Funds is 15% plus cess and surcharge, applicable for investments held for less than one year.
• Long-term Capital Gains Tax (LTCG) on Equity Mutual Funds exempts gains up to Rs. 1 lakh, and gains exceeding Rs. 1 lakh are taxed at 10% plus cess and surcharge.
• Debt Funds sold within three years before April 1, 2023, are taxed based on the individual's income tax slab, while those held for more than three years are taxed at 20% after indexation.
• Under the new rule, all debt funds purchased after April 1, 2023, are taxed based on the individual's income tax slab, regardless of the holding period.
• ELSS investments have a lock-in period of 3 years.