Everything to Know about Taxation of Mutual Funds in India
With the spread of investors’ awareness, more and more people are choosing mutual funds to fulfil their financial objectives and goals. Some of the advantages of this investment option include portfolio diversification, high liquidity and expert fund management. There are also certain tax benefits of investing in mutual funds.
Returns from mutual funds are taxed differently from salary or business income. In the following sections, you will get to know about the rules of taxation of mutual funds in India.
What Factors Determine Mutual Fund Taxation?
First, let us take a look at the important factors that determine taxation in a mutual fund:
Mutual funds are broadly classified as either equity or debt funds based on their asset allocation. Therefore, the income tax amount an investor has to pay depends on the type of mutual fund they have invested in. Mutual fund is classified as an equity fund if it invests 65% of its corpus in equity and equity-related instruments. Any other fund with less than 65% investment in equities is considered as a debt fund. Debt funds invest in fixed-income instruments such as corporate debt securities, government bonds, etc
- Holding period of the investment
The investment duration plays an important role in determining the tax that an investor has to pay. Therefore, the holding period of the mutual fund units can be classified as either long-term or short-term.
For equity mutual funds, a holding period of less than 12 months is short-term, and more than 12 months is long-term. For debt mutual funds, a holding period of less than 36 months is short-term and more than 36 months is long-term.
- Types of gains generated
When an individual invests in mutual funds, they can earn returns in two ways. The investor can receive capital gains after redeeming their fund units. They can also earn dividends. Let’s understand them in detail:
- Capital gains
When an investor sells off their mutual fund units after a specified duration, they will earn capital gains. This is defined as profits from the sale of mutual funds. An investor has to sell the fund units at a higher price than the cost price to earn capital gains.
Asset Management Companies, commonly referred to as AMCs, declare dividends solely from the realized profits in their investment portfolio. Therefore, they cannot declare dividends if the portfolio valuation has increased, but the profits remain unrealised.
Mutual fund companies can declare dividends only under Income Distribution cum Capital Withdrawal (IDCW) Plans and not growth plans. Moreover, after the distribution of dividends, the NAV of the scheme would decrease in proportion to that particular amount and the corresponding statutory levy.
Therefore, more than being a source of income from mutual funds, dividends can be defined as a partial liquidation of the fund’s NAV.
What Are the Taxation Rules for Dividends?
Before 2020, investors who received dividends did not have to pay any tax upon it. This is because the fund houses that issued the dividends were responsible for paying the Dividend Distribution Tax (DDT) before its distribution.
However, there has been a change in this rule. As a result, AMCs are not required to pay DDT on any amount they distribute as dividends from AY 2021-2022. Instead, the dividends are added to an investor’s income and taxed as per the applicable income tax slab rate.
So, people in the higher tax slab, for instance, 20% or 30%, might be at a disadvantage while receiving dividends as taxable income as opposed to taxation of capital gains.
Moreover, AMCs will have to deduct TDS (Tax Deducted at Source) at 10% of the dividend income if the dividends exceed Rs. 5000 in a fiscal year. Keep in mind that the TDS rate will increase to 20% if the investor’s PAN (Permanent Account Number) is not linked with their Aadhaar card.
Also Read: Invest in Tax Saving Mutual Funds in India
Taxation Rules for Equity Funds
Detailed below are taxation rules for equity funds:
- If the investor redeems the equity fund investment before 12 months, the capital gains are referred to as STCG or short-term capital gains. The applicable tax rate is 15%, irrespective of the slab rate of the investor.
- However, if the individual redeems their units after 1 year, the capital gains are treated as LTCG or long-term capital gains. Note that LTCGs up to Rs. 1 lakh are tax-exempt. If the capital gains exceed this specific amount, then the LTCG tax rate of 10% will be applicable. However, investors will not receive the benefit of indexation.
Taxation Rules for Debt Funds
- If an investor redeems their debt fund units within 36 months from the investment, the person’s capital gains are deemed as STCG. Accordingly, these gains are added to an individual’s income and get taxed as per the applicable income tax slab rate.
- However, if an individual redeems their debt fund units after 36 months, capital gains are deemed as LTCG. The applicable LTCG tax rate is 20% after indexation. When the cost of investment is adjusted for inflation, it is referred to as indexation.
Also Read: Short-Term vs Long-Term Investments
Taxation Rules for Hybrid Funds
Hybrid mutual funds aim to balance growth and income by investing in equity and debt instruments. The taxation of hybrid funds depends on their equity component. The following are the rules of taxation of hybrid mutual funds:
- Note that if the equity component in a hybrid fund exceeds 65%, then the fund will be taxed like an equity fund.
- If the equity component is less than 65%, the hybrid fund will be taxed like a debt mutual fund.
A Chart of Mutual Fund Taxation
|Type of Fund||Holding period for STCG||Taxation for STCG||Holding period for LTCG||Taxation for LTCG|
|Equity Mutual Funds||Less than 12 months||15% + Cess + Surcharge||More than 12 months||Tax-exempt up to – Rs. 1 lakh For amounts above Rs. 1 lakh – 10% + Cess + Surcharge|
|Debt Mutual Funds||Less than 36 months||Taxed as per the investor’s tax slab rate||More than 36 months||20% + Cess + Surcharge|
|Equity-oriented Hybrid Funds||Less than 12 months||15% + Cess + Surcharge||More than 12 months||Tax-exempt up to -Rs. 1 lakh For amounts above Rs. 1 lakh – 10% + Cess + Surcharge|
|Debt-oriented Hybrid Funds||Less than 36 months||Taxed according to the investor’s tax slab rate||More than 36 months||20% + Cess + Surcharge|
Tax benefits of ELSS funds
ELSS (Equity Linked Savings Schemes) funds are ideal if an individual wish to get tax benefits by investing in mutual funds. These schemes invest at least 80% of their total assets in equity instruments. According to Section 80C of the Income Tax Act, investors can avail tax deductions up to Rs. 1.5 lakh if they invest in ELSS funds.
These funds have a lock-in period of 3 years, so investors always have to pay long-term capital gains tax only on capital gains derived from selling ELSS units.
Also Read: Best ELSS Funds to Invest in 2022 in India
What Are the Taxation Rules for SIP investments?
SIP or Systematic Investment Plan is a common investment mode for mutual funds. It teaches financial discipline and helps people effectively shape their different financial goals. Note that every investment via SIP is considered a new investment, and accordingly, taxes are applicable.
Investors buy units of their chosen scheme via SIP instalments. The redemption of these units follows the FIFO or the ‘first in, first out’ principle. According to this, units that are bought first will be redeemed first and then subject to mutual fund taxation.
For instance, Riya started investing in a debt mutual fund through a monthly SIP in January 2018 and invested in the fund till January 2022. In January 2022, Riya redeemed all units from the fund. Now, how will her gains be calculated?
The SIPs between January 2018 to January 2019 will incur long-term capital gains tax as their holding period is more than 36 months. The tax will be levied at 20 percent with an indexation benefit. But for the SIPs after January 2019, a short-term capital gains tax would apply. The gains will be added to Riya’s income and taxed as per her income tax slab.
What Is the Securities Transaction Tax (STT)?
There is another tax that people need to be aware of if they decide to invest in mutual funds. The Government of India levies Securities Transaction Tax, commonly referred to as STT, on purchasing and selling securities that are listed on the recognized stock exchanges in India.
Currently, the Ministry of Finance charges an STT of 0.01% for the buying and selling of units of equity or an equity-oriented hybrid fund. However, STT is not applicable for debt fund units.
To conclude, knowing the rules of taxation of mutual funds is crucial to make more informed investment decisions. The scheme type and the fund units’ holding period determine the taxes on capital gains from the fund. This blog has detailed the taxation policies of both equity and debt funds which will help people plan their investments.
Frequently Asked Questions
When was Dividend Distribution Tax withdrawn?
Finance Act 2020 withdrew Dividend Distribution Tax (DDT) which AMCs had to pay earlier. Now, dividends are added to an investor’s income and are taxed as per the slab rate.
Who should opt for tax-saving mutual funds?
The risks associated with ELSS or tax-saving funds are considerably high. So, people with a high-risk appetite should opt for this investment option.
How can you calculate the STCG and LTCG applicable to your income?
One can use the following formulas to calculate capital gains:
STCG = Full value of consideration – (expenses incurred for the transfer + cost of acquisition)
LTCG = Full value of consideration – (expenses incurred for the transfer of asset + indexed cost of acquisition )