Understanding Taxes on Mutual Funds: A Comprehensive Guide

Mutual funds are generally considered as one of the most fruitful investment options as it plays a crucial role in achieving your financial goals easily. One of the greatest advantages of investing MFs is they are also tax-efficient investment instruments. Investment in a mutual fund can reward you with tax-efficient returns.

If you are planning to invest in mutual funds, you might be making a mistake without considering tax. The reason is that it will affect your cash flow. In addition to taxation, an investor should also check on factors such as taxation on dividends, redemption, etc.

In this blog, we seek to discuss how taxation may impact the returns from mutual funds.

Source of Income from Mutual Funds

Before we delve deeper into the taxation angle, let us discuss the sources of income from mutual funds.

Income from mutual funds can be either from –

• Regular dividend
• Sale of shares in funds

Let us discuss dividends first.

Dividends received from funds are exempted from tax. A DDT of 25% is levied on non-equity-oriented schemes along with a 12% surcharge and 4%cess, making an effective DDT amounting to 29.12% for both resident Indians and NRIs.

Capital gain tax on mutual funds

Before understanding the taxation structure on capital gains, we need to understand capital gains from the point of the mutual fund holding period.

Since capital gains are taxed by income tax authorities, the quantum of tax to be paid depends on the holding period. The holding period can be classified into two broad categories – Short-term and long-term.

The following table gives an idea of what constitutes short-term and long-term

Funds Short-term Long-term Equity  < 12 months  > = 12 months Balanced  < 12 months  > = 12 months Debt  < 36 months  > = 36 months

Taxation

a) Long-term capital gains

1.Tax saving equity funds

• An investment made under ELSS (Equity Linked Savings Schemes) qualifies for tax exemption under section 80C. The total savings under 80C that qualifies for exemption is Rs.1.5 lakhs (max).
• Apart from ELSS, other payments like LIC, PF, Children’s school fees, etc also qualify.
• If an investor has no other deduction in 80C, he can invest a maximum of Rs.1.5 lakhs to qualify for tax exemption. If the investor is in the 20% tax bracket, he saves Rs.30000 tax.
• If the investor claims a Rs.50,000 exemption on payment of children’s school fees, PF, etc, he can invest Rs.1 lakhs in ELSS. The maximum permissible exemption under 80C is Rs.1.5 lakhs
• ELSS comes with a locking period of 3 years. The investor can’t redeem the units before 3 years.
• Long Term Capital Gain (LTCG) Tax on redemption is exempted up to Rs.1 lakh. If LTCG is more than 1 lakhs, the applicable tax is 10% without indexation

2. Non-tax saving equity funds

Long Term Capital Gain (LTCG) Tax on redemption is exempted up to Rs. 1 lakh. If LTCG is more than 1 lakh, the applicable tax is 10% without indexation.

b) Short-term capital gains

Short-term capital gains are taxed @ 15%

1. Debt funds

• Long-term capital gains (=>36 months) on debt funds are taxed at 20% after indexation. (Indexation takes into consideration the inflation between the year of purchase of debts funds and the year of sale of debt funds)
• Short-term capital gains (< 36 months) on debts funds are added to your income and taxed as per the applicable slab your income falls under (5% or 20% or 30%)

2. Balance fund

They are equity-oriented funds that invest 65% (minimum) of assets in equities. These are taxed as, “Non-tax savings equity funds”.

3. Systematic Investment Plan (SIP)

Each investment is considered a new venture and capital gains are taxed accordingly.

The following example will help to understand tax:

One investor invests Rs 5,000 per month starting from April 2020

Another investor invests Rs 60,000 lump sum at the same time

Both redeem their entire funds.

In the case of a SIP investor, Rs 5,000 will qualify for tax exemption as the investment made in April 2020 would have exceeded more than 1 year as of May 2021

In the case of an investor who invests Rs 60,000 lump sum in April 2020, the entire capital gain is exempted.

Happy Investing!

Disclaimer: The views expressed in this post are that of the author and not those of Groww.