How Mutual Funds are Taxed - Mutual Fund Taxation

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Mutual Funds Taxation

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.

Key Highlights

  • Tax Depends on Holding Period and Fund Type
  • Debt Funds are Taxed at Income Slab Rate
  • SIP Investments are Taxed Unit-wise

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. 

  • Mutual funds might give you a bonus (dividend) from their profits. Under section 194k of the Income Tax Act, a small cut (10% TDS) is applied before you get your dividends, but only if the total dividend for the year is over Rs. 5,000. Later, you can get that 10% back when you file your taxes.
  • How long you hold onto your MF units before selling matters when it comes to taxes. This period is “Holding Period”. In India, the government encourages investors to hold onto their investments for a longer time. So, if you sell them after holding units for a shorter period (usually less than a year), you might have to pay more tax on your capital gain.

Taxation on Dividends Received From Mutual Funds

Dividends paid to investors by Indian companies remained tax-free until March 31, 2020. Dividends are now taxable at the applicable slab rates, however, as a result of the Finance Act of 2020's introduction and repeal of the Dividend Distribution Tax (DDT). Businesses that distribute dividends must deduct 10% of dividends over ₹5,000 in a fiscal year for Tax Deducted at Source (TDS).

Taxation on Capital Gains from Mutual Funds

As said, capital gains are broadly classified into short-term capital gains (STCG) and long-term capital gains (LTCG), so each type of mutual fund is taxed differently.

Type of Mutual FundHolding PeriodCapital Gain Tax
Equity FundsUp to 1 year15%
 More than 1 yearExempt from tax up to a gain of ₹1 lakh per year. Gains exceeding ₹1 lakh are taxed at 10% without indexation benefit.
Debt FundsN/ATaxed as per your income tax slab rate.

Note: Debt Fund taxation changed in 2023. These funds now face taxes based on your income slab, similar to Fixed Deposits. This eliminates the previous advantage of indexation for long-term gains. This change affects not only Debt Funds, but also Gold Funds, Hybrid Funds, and International Equity 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 instalment, you are allotted certain mutual fund units. The period of capital gain is decided accordingly.

  • For example, if you have invested every month for 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.

Steps to Declare Mutual Fund Investments in ITR

When an investor earns a capital gain during the fiscal year, they must file either ITR-2 or ITR-3. Do remember these are filed for the year when an investor redeems their mutual fund units. If an investor has capital gains in a given year, they must file an ITR-2. Here are the steps to declare your mutual fund investments while filing ITR:

  1. Login to income tax website.
  2. Choose ITR form, status, and year.
  3. Select "Income Schedule" and "Schedule Capital Gains."
  4. Report short-term or long-term gains (details vary).
  5. Confirm schedules and preview return.
  6. Provide details and validate ITR.
  7. Verify ITR electronically or via ITR-V form.

Conclusion

Unlike the initial impression, understanding mutual fund taxation boils down to two key factors: holding period and fund type (equity or debt). While tax calculations can seem daunting, especially near tax filing deadlines, familiarising yourself with these basics gets you to make informed investment decisions and potentially maximise your returns. With proper planning and a grasp of the tax implications, mutual funds can be a powerful tool for achieving your financial goals.

FAQs

  • Is mutual fund SIP tax free?

  • Do we have to pay tax on mutual funds?

  • Is SIP better than FD?

  • Do we need to show mutual funds in ITR?

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