As an investor, it is important to understand the tax implications of your investment choices. Mutual funds are a popular investment option for many people, offering diversification and professional management. However, the taxation of mutual funds can be complex and confusing. In this article, we will explore how mutual funds are taxed and provide you with the information you need to make informed investment decisions. From understanding the different types of mutual fund taxes to exploring strategies to minimize your tax liability, we will cover all the essential aspects of mutual fund taxation.
Types of Mutual Fund Holding Periods
The holding period for your mutual fund investment (How long ago you purchased the mutual fund) is of 2 types:
1. Long-Term Holding Period
For equity mutual funds: a holding period of 12 months or more is regarded as the ‘Long term’.
For debt funds: a holding period of 36 months or more is regarded as the ‘Long term’.
2. Short-Term Holding Period
For equity mutual funds: a holding period of fewer than 12 months is regarded as the ‘Short term’.
For debt funds: Debt funds held for less than 36 months are regarded as ‘Short-term’.
The following table gives a glimpse of the holding period classification of mutual funds:
|Equity funds||Less than 12 months||12 months and more|
|Balanced funds (equity-oriented)||Less than 12 months||12 months and more|
|Balanced funds (debt-oriented)||Less than 36 months||36 months and more|
|Debt funds||Less than 36 months||36 months or more|
Hybrid equity-oriented funds (equity exposure of more than 65%) are considered equity funds for taxation. If the equity exposure in a hybrid fund is less than 65% or is equally exposed to equity and debt instruments, i.e. 50% equity and 50% debt, then it is considered a debt fund for taxation.
The holding period of your Mutual Funds plays a major role to determine how mutual funds are taxed.
Consider reading: Types of Mutual Funds in India
Taxation on Mutual Funds
The taxation on Mutual funds depends on the Mutual Fund type. Let’s look at Taxation based on the type of Mutual Funds:
1. Equity Funds
- Short-term capital gains(STCG): If any stock or equity-oriented mutual fund (more than 65% equity portfolio) is sold before 12 months of purchase, a 15% tax would be applicable on the gains.
- Long-term capital gains(LTCG): If any stock or equity-oriented mutual fund (more than 65% equity portfolio) is sold after 12 months of purchase then gains up to Rs 100,000 are exempt from Income tax. All gains above this limit are taxed at 10%.
2. Debt Funds
- Short-term capital gains(STCG): If any debt instrument or debt-oriented mutual fund is sold before 36 months of purchase, the returns or short-term capital gains are added to your income and taxed according to the income tax slab (0%, 5%, 20% or 30%). applicable to the investor.
- Long-term capital gains(LTCG): If held for more than 36 months, all gains are treated as long-term capital gains and taxed at 20% with indexation benefit. Indexation helps you to inflate your purchase cost with the cost of inflation index and bring down your tax liability.
Update effective 1st April 2023: The Indian Government has announced that all debt funds will lose indexation benefits.
If you are planning to sell your debt mutual fund then your tax slab matters a lot. If you are in a 30% bracket and sell your debt mutual fund within 3 years then you end up paying a lot of taxes on your profit!
3. Balanced Funds
Balanced funds are taxable depending on their equity exposure. Hybrid equity-oriented funds are taxed as any other equity fund while hybrid debt-oriented funds are taxed as any other debt fund.
4. Systematic Investment Plans or SIPs
Often people get confused about how SIP in mutual funds is taxed.
The taxation of SIP investment is done on a pro-rata basis. Each SIP, treated as a new investment, attracts taxes on its gains separately.
For instance, you initiate a SIP of Rs 10,000 a month in an equity fund for 12 months. Each SIP is considered to be a new investment. Hence, after 12 months, if you decide to redeem your entire accumulated corpus (investments plus gains), all your gains will not be tax-free.
Only the gains earned on the first SIP would be treated for Long term capital gains(LTCG) tax because only that investment would have been completed one year. The rest of the gains would be subject to Short term capital gains(STCG) tax.
5. Securities Transaction Tax (STT)
Apart from these, there is another type of tax called the Securities Transaction Tax (STT). An STT of 0.001% is levied by the government (Ministry of Finance) when you decide to sell your units of an equity fund or a hybrid equity-oriented fund. There is no STT on the sale of debt fund units.
As you can see above the type of Mutual funds determine how mutual funds are taxed.
How to Save Tax on Mutual Funds Returns in India?
There are several ways to save taxes on mutual fund investments in India:
- Choose tax-efficient mutual funds: Some mutual funds are designed to be tax-efficient, which means they generate fewer capital gains and distribute fewer dividends, resulting in lower tax liabilities for investors. For example, index funds and exchange-traded funds (ETFs) are typically more tax-efficient than actively managed funds.
- Invest in tax-free mutual funds: Some mutual funds, such as those that invest in infrastructure projects and small-scale industries, are eligible for tax exemptions under certain conditions. These mutual funds can provide tax-free returns to investors, making them an attractive option for tax savings.
- Hold investments for a longer period: As mentioned earlier, long-term capital gains (LTCG) from mutual fund investments are taxed at a lower rate than short-term capital gains (STCG). By holding mutual fund investments for more than 36 months, investors can avail the benefits of the lower LTCG tax rate.
- Use a tax-saving mutual fund scheme: Many mutual fund companies offer tax-saving mutual fund schemes, also known as Equity Linked Savings Schemes (ELSS), which offer tax deductions under Section 80C of the Income Tax Act. Investments in these schemes are eligible for a tax deduction of up to INR 1.5 lakh per financial year.
- Utilize tax-saving strategies: Investors can use other tax-saving strategies, such as transferring mutual fund investments to a spouse or donating mutual fund units to a charitable organization, to reduce their tax liability.
- Leverage Tax loss harvesting: Selling shares of mutual funds that have declined in value is a method known as Tax loss harvesting that can be used to offset capital gains and perhaps lower tax obligations.
How Mutual Funds are Taxed? – Closing Thoughts!
It is imperative to understand the taxation on mutual funds so that you can most money out of your mutual funds. At the same time, you shouldn’t invest in mutual funds only to save taxes. Have a clear vision of why you are investing in a mutual fund and whether is it giving you the value you have expected.
We hope by now you have understood how mutual funds are taxed, Consider reading How to select mutual funds India? which will help you how you should select your next mutual fund for investments.
FAQs on How Mutual Funds are Taxed
How to calculate tax on sip in mutual funds?
Taxes on SIP returns are done on a pro-rata basis i.e. When you invest your money in a SIP then the data of the SIP transaction is taken for tax purposes for the number of units allocated for the money you have invested.
Are mutual fund returns taxable?
Yes. mutual fund returns are taxable as per the fund type. Equity and debt mutual funds are taxed differently as per the holding period. Debt funds have the option to have indexation benefits which equity mutual funds do not have!
Is ELSS mutual fund returns tax-free?
No. Returns from ELSS funds will be eligible for long-term capital gains tax since they have a lock-in period of 3 years. However, investors do not need to pay any tax if their gains from mutual funds are under 1 lakh rupees. If you have gained over 1 lakh rupees for the financial from the mutual fund you need to pay long-term capital gains tax.
Are dividends from mutual funds taxable in India?
Yes, dividends from mutual funds are taxable in India. Dividends are taxed at a rate of 10% for resident individuals and Hindu Undivided Families (HUFs). Non-resident individuals and foreign companies are taxed at a rate of 20%.