What are the Tax Implications on Mutual Funds?

Any investment’s primary goal is to increase wealth. Mutual funds are practical financial tools that help with this goal by increasing in value. Gains from mutual funds are taxable, just like gains from other assets.

The type of asset the fund concentrates on and the time you hold your investment determine the tax you pay on mutual funds. The equity-linked savings plan, or ELSS fund, is a unique type of mutual fund that can help you save on taxes.

Capital gains tax is applicable on mutual fund investments. It is paid on the revenue we generate when we redeem or sell our mutual fund investments (units). The profit is the difference between the scheme’s Net Asset Value (NAV) on the sale date and the purchase date (Selling Price-Purchase Price). Capital gains tax is further divided depending on the holding period’s length. A long-term holding period of a year or longer is regarded as long-term for equity funds (funds having an equity exposure more significant than 65%) and subject to Long-Term Capital Gains (LTCG) tax.

If the total capital gain in a financial year exceeds INR 1 lakh, an LTCG tax of 10% applies to equity funds. Keep in mind that your gains are tax-free up to INR 1 lakh when making financial plans. It applies to all investments made beginning after January 31, 2018. In equities funds, profits from holdings that last less than a year are subject to a 15% Short-Term Capital Gains (STCG) tax.

In the case of non-equity funds (debt funds), long-term is defined as a holding period of three years or longer, and a 20% LTCG tax is imposed on such holdings with indexation, meaning that the purchase price is increased to account for inflation when computing capital gains. The highest income tax bracket for individuals is the STCG tax, which is applied to profits on fewer than three years of holdings.

Key Factors That Determine the Taxation of Mutual Funds in India

The fundamentals of mutual fund taxation are much simpler to understand when they are further broken down into smaller pieces. So let’s start by taking a look at the three variables that affect the tax liabilities of mutual funds.

  • The kind of financing Mutual funds are divided into two groups for tax purposes: equity-oriented mutual funds and debt-oriented mutual funds.

  • The nature of the gains (dividends or capital gains): A capital gain is a profit you make when you sell a capital asset for more money than it cost you, but a dividend is a portion of earnings the mutual fund house distributes to the scheme’s investors without the Investor having to sell the asset.

  • Your time on hold: The amount of tax you’ll pay on your capital gains depends on the holding period. Less tax will be due if your holding term is longer. Because India’s income tax laws favor longer holding times, keeping your investment longer lowers your tax burden.

Scheme Orientation

The type of mutual fund you invest in will influence the tax on the capital gains after you know your holding period. Mutual funds typically fall into the debt and equity categories. But it’s also crucial to discuss hybrid funds in order to comprehend their taxation. In more depth, let’s go over each category’s specific tax treatment of mutual funds.

Taxation on Equity

For tax reasons, an equity-oriented mutual fund scheme allocates at least 65% of its capital to Indian equities or equity-related derivatives. For taxation purposes, all other funding is regarded as debt-oriented programs.

Prior to 2018, LTCG on the sale of equity shares or equity-oriented mutual fund schemes was exempt under Section 10(38). According to section 112A of the Income Tax Act of 1961, mutual funds (equity-oriented schemes) are currently subject to LTCG income tax at a rate of 10% on capital gains exceeding 1 lakh.

For example, regardless of your income tax bracket, if you generated an LTCG of 1,20,000 through an equity-oriented scheme during a financial year, your tax would be assessed on 20,000 at 10% (plus cess and surcharge as appropriate).

Section 111A of the Income Tax Act of 1961 states that 15% STCG tax is applied to the sale of units of equity-oriented mutual fund schemes. For example, regardless of your income tax bracket, if you made 1,30,000 in STCG from an equity-oriented plan during a financial year, your tax would be computed on that amount at a rate of 15% (plus any relevant levy and surcharge). This is because STCG tax does not have the same 1 Lakh exemption as LTCG tax.

Equity-Linked Savings Scheme (ELSS)

Mutual fund programs known as ELSS invest at least 80% of their net assets in stocks. This program is what you want if you’re looking for tax advantages for mutual funds. Under Section 80C of the Income Tax Act of 1961, investments in ELSS are tax deductible up to a maximum of 1.5 lakh. It should be noted that section 80C has a 1.5 lakh rupee cap on it. The amount that is deductible for your contributions to ELSS will be reduced if you are already deducting expenses for other items covered by Section 80C, such as LIC premium.

How Do You Earn Returns in Mutual Funds?

Dividends and capital gains are the two types of rewards offered to investors by mutual funds. If there are any company profits, they are used to pay dividends. When businesses have extra cash on hand, they may choose to distribute it to investors as dividends. Investors earn dividends in proportion to the number of units they own in mutual funds.

If an investor sells a security they own for more money than they paid for it, they will have realized a capital gain. In plain English, capital gains are realized as a result of an increase in the price of mutual fund units. Investors in mutual funds must pay taxes on both dividends and capital gains.

Taxation of Dividends Offered by Mutual Funds

Dividends offered by any mutual fund plan are subject to traditional taxation, per the changes introduced in the Union Budget 2020. In other words, investors who get dividends have increased taxable income and are subject to tax at the rates applicable to their individual income tax slabs.

Before the Tax Cuts and Jobs Act of 2001, firms were required to pay dividend distribution tax (DDT) before paying dividends to investors. As a result, dividends were tax-free in the hands of investors. Under this system, investors were not subject to tax on dividends (received from domestic enterprises) up to Rs 10 lakh per year. Dividend distribution tax, which is 10%, is applied to any dividends that exceed Rs 10 lakh every fiscal year.

Taxation of Capital Gains Offered by Mutual Funds

The tax rate applied to capital gains varies depending on the mutual fund’s holding period and kind. The length of time an investor held units of a mutual fund is known as the holding period. The interval between the date of purchase and disposal of mutual fund units is known as the holding period.

Taxation of Capital Gains When Invested Through SIPs

Mutual fund investments can be made using systematic investment plans (SIPs). They are made so that investors can regularly invest a small sum in a mutual fund program. Investors have the option of selecting the frequency of their investments. All viable options are weekly, monthly, quarterly, bi-annually, or annually.

You buy a set amount of mutual fund units with each SIP installment. First-in, first-out procedures are followed while handling these redemptions. Consider making a one-year SIP commitment in an equities fund, then choosing to reinvest the entire amount after 13 months.

In this scenario, the first SIP-purchased units are held for a long time (more than a year), allowing you to realize long-term capital gains on them. You don’t have to pay any tax if your long-term capital gains are less than Rs. 1 lakh.

On the units acquired through SIPs, however, you begin to realize short-term capital gains after the second month. Regardless of your income tax bracket, these gains are taxed at a flat rate of 15%. The necessary cess and surcharge will need to be paid on it.

Asset Categorization

For taxation purposes, any mutual fund that invests more than 65% of its corpus in domestic firm shares is referred to as an equity-oriented fund. If the investment in the cash market satisfies the requirement of at least 65% investment in domestic firm shares, arbitrage funds that invest to profit from the difference in prices in the cash and derivative markets are taxed as equity-oriented funds.

Different fixed-income securities are taxed differently by debt funds (i.e., non-equity-oriented funds) than by equity-focused funds. International funds that invest in foreign stocks and fund-of-funds that profit from holdings in other mutual funds are taxed similarly to debt funds.

Only if hybrid funds have at least a 65% exposure to domestic firm shares are they considered equity-oriented funds. They are handled as debt funds if not.

ELSS mutual funds are tax-saving mutual funds even though they invest largely in the stock market. The three-year minimum lock-in period distinguishes ELSS from other equity-oriented funds.

If you choose the dividend option, dividends will be subject to taxation in the hands of the investors. Before payments or reinvestment, the mutual fund will deduct TDS at a rate of 10% for resident investors and 20% (plus any relevant surcharge and cess) for non-resident investors. However, when completing their yearly return, the Investor can claim a tax credit for the deducted TDS.

Holding Periods

The holding term is the length of time that you keep your mutual fund investment. A different tax rate applies to short-term investments than to long-term ones.

Short-term taxation

Investments made for less than a year in any equity-oriented mutual fund are deemed short-term and are subject to a 15% short-term capital gains tax.

A holding duration of fewer than 36 months is regarded as a short-term investment for debt funds. Debt fund short-term capital gains are taxed based on your specific income tax bracket.

Long-term taxation

If the total long-term capital gains amount from equity-oriented mutual funds/equity shares exceeds 1,00,000 in a year, gains from equity mutual funds held for more than 12 months are subject to long-term capital gains tax at a rate of 10%. Returns that fall below that amount are tax-free.

Contrarily, if held for more than 36 months, gains from debt funds are taxed at a rate of 20% after the indexation benefit. Gains that have been indexed for inflation are gains. The tax on debt funds would be higher in the absence of indexation.

Tax-saving mutual funds

You can deduct your investment in an ELSS fund from your taxes. According to Section 80C of the Income Tax Act of 1961, you can save up to 1,50,000. Despite being primarily an equity fund, it is one of the best tax-saving solutions available to investors due to the three-year lock-in period and the high chance of return.

Securities Transaction tax

All equity-oriented funds are subject to a securities transaction tax of 0.001% at redemption, in addition to the abovementioned taxes. You do not need to pay STT separately because investors receive the fund after deduction for it.

SIP taxation

The tax on systematic investment programs is computed per unit. Whether it will be subject to short- or long-term capital gains tax depends on the holding time from the purchase date to the redemption date. The first-in, first-out rule, which states that the first units purchased are regarded as sold first, is implemented if redemption is carried out in segments.

Things to Remember

  • According to the asset type and investment length, mutual funds are taxed differently.

  • Mutual funds that focus on equity are subject to a 15% short-term capital gains tax for holding periods up to 12 months. Beyond that, gains (from equity-oriented mutual funds and equity shares) over 100,000 are subject to a long-term capital gains tax of 10%.

  • Debt mutual funds that are kept for a maximum of 36 months are taxed according to your income tax bracket. After accounting for inflation, a long-term capital gains tax of 20% is then applicable.

  • Tax deductions for equity-linked savings plans are allowed for up to £150,000 annually.

  • Investors must pay taxes on their dividend income.

  • The mutual fund shall deduct TDS @10% for resident investors and @20% (plus relevant surcharge and cess) for non-resident investors on dividend distributed.

Conclusion

Mutual funds can still assist you in achieving your financial objectives with smart preparation, notwithstanding taxes. Funds become more tax-efficient when they are held for a long time. When calculating your returns, consider tax.