Mutual fund taxation: How are mutual funds taxed?

Mutual fund taxation

Mutual funds are popular investment vehicles that help investors generate inflation-adjusted returns over time. Yet, investors have only a basic understanding of tax on mutual funds. This blog post will give you a ringside view of the topic. Let’s dig in.

What is tax on mutual funds?

Tax on mutual funds is the tax investors pay on their mutual fund investments. The tax applies to capital gains from selling the mutual fund units. Capital gains can be classified as short-term capital gains if the units are held for less than a year or long-term if they are held for more than a year. The investor must pay tax according to his slab rate for short-term capital gains, while the tax rate for long-term capital gains is generally lower. Investors must report their mutual fund capital gains in their income tax return and pay the applicable tax amount.

Factors to determine the tax on mutual funds

The holding period plays a crucial role among all the factors determining the mutual fund tax. If you hold the units for less than a year, short-term capital gains will apply, while long-term capital gains will apply for holdings above a year. The tax rate also depends on the type of mutual fund. The long-term capital gains tax rate for equity mutual funds is currently 10%, while for debt mutual funds, it is 20% after the indexation benefit.

Capital gain is the difference between the selling and purchase prices of mutual fund units. The tax liability increases with an increase in the capital gains amount. We have seen that the tax rate for short-term capital gains is based on the investor’s income tax bracket, while the tax rate for long-term capital gains depends on the investor’s income tax bracket. Indexation benefit is a tax provision that allows investors to adjust the purchase price of the mutual fund units for inflation when calculating capital gains. This reduces the tax liability for long-term capital gains.

Fund types

Mutual funds fall into various types based on the investment objective, asset allocation, and risk profile. Some common types of mutual funds include equity funds, debt funds, balanced funds, index funds, and sectoral funds.

Dividend

Dividends in mutual funds refer to the portion of the profits distributed to investors periodically. Profits from the mutual fund and the number of units the investor holds will determine the dividend amount. Dividends can be paid out to the investor or reinvested to purchase more units.

Capital gains

Capital gains in mutual funds refer to the investors’ profits when they sell mutual fund units. It can be short-term if the units are held for less than a year or long-term if held for more than a year.

Holding period of investor

Investors’ holding period refers to the length of time for which they hold the mutual fund units. The holding period determines the tax liability on the capital gains earned from selling the units. We have discussed short-term and long-term capital gains tax above.

How to earn returns in mutual funds

There are several ways to earn returns from investing in mutual funds. One is capital appreciation, where investors can earn returns by selling mutual fund units at a price higher than the purchase price. This holds especially true for equity funds, where the fund’s stock investments can grow in value over time. Investors can also earn from dividends that mutual funds pay periodically to investors from profits. Investors can save these dividend returns or reinvest them to purchase more units.

Some debt mutual funds invest in fixed-income securities such as bonds, debentures, and government securities that generate interest income. Investors can earn returns from the interest income these investments generate. On another note, systematic investment plans (SIP) help investors earn returns through the power of compounding by investing in mutual funds. Regular investments through SIPs can help investors accumulate a significant corpus over a long period.

Taxation on dividends

In India, dividends received from mutual funds are taxable in the hands of the investors as per income tax laws. The dividend income from mutual funds is added to the investor’s total annual income and taxed as per the applicable income tax slab rates. Investors must disclose the dividend income while filing their income tax returns. Note that equity and debt mutual funds are taxed differently on dividends. Dividends received from equity mutual funds are taxed at a flat rate of 10% (excluding surcharge and cess), while dividends received from debt mutual funds are taxed at the investor’s applicable income tax rate.

Taxation on capital gain

In India, the taxation on capital gains on mutual funds is either a short-term or a long-term tax. Short-term capital gains (STCG) arise when an investor sells mutual fund units within one year of purchase. The STCG on equity mutual funds are taxed at a flat rate of 15% (excluding surcharge and cess), while the STCG on debt mutual funds are added to the investor’s total income and taxed at their applicable income tax rate.

Long-term capital gains (LTCG) arise when an investor sells mutual fund units after one year of purchase. The LTCG on equity mutual funds up to Rs. 1 lakh in a financial year is tax-free. Beyond that, the LTCG on equity mutual funds is taxed at 10% (excluding surcharge and cess) without indexation benefit or 20% (excluding surcharge and cess) with indexation benefit. The LTCG on debt mutual funds after indexation benefit attracts a tax rate of 20% (excluding surcharge and cess).

Scheme orientation

Scheme orientation in mutual funds refers to the investment objective of a particular mutual fund scheme. The investment objective outlines the fund’s goal and the fund manager’s strategy to achieve that goal. For example, a mutual fund scheme with a large-cap orientation will invest primarily in large-cap stocks, while a mid-cap-oriented scheme will invest mainly in mid-cap stocks. Similarly, a debt-oriented scheme primarily invests in debt instruments like bonds and fixed deposits.

Taxation on equity

Equity mutual funds are subject to taxation on capital gains. Short-term capital gains on equity funds are taxed at 15%, while long-term capital gains are taxed at 10% (up to Rs. 1 lakh) and 20% (above Rs. 1 lakh).

Long-term capital gains on mutual fund: Equity schemes

Long-term capital gains on equity mutual funds are those gains that arise when the investor sells the units of the mutual fund after holding them for more than one year. The LTCG on equity mutual funds is taxed at 10% (up to Rs. 1 lakh) and 20% (above Rs. 1 lakh).

Short-term capital gains on mutual fund: Equity Schemes

Short-term capital gains on equity mutual funds apply when the investor sells the mutual fund units before holding them for one year. The STCG on equity mutual funds attracts a flat rate of 15%.

Equity-linked savings scheme (ELSS)

ELSS is a type of equity mutual fund that provides tax benefits under Section 80C of the Income Tax Act. Investments up to Rs. 1.5 lakh in ELSS are eligible for a deduction from taxable income.

Short-term capital gains on mutual fund: Debt schemes

Short-term capital gains on debt mutual funds apply when the investor sells the fund units before holding them for three years. The STCG on debt mutual funds are added to the investor’s total income and taxed at their applicable income tax rate.

Taxation on hybrid funds

Taxes on hybrid mutual funds, which invest in equity and debt instruments, apply to the proportion of investments in equity and debt. The tax implications for hybrid mutual funds vary depending on the type of hybrid fund and the investor’s holding period.

How to declare mutual fund investments in ITR

Investors can declare their mutual fund investments in their income tax returns (ITR) by providing the investment details in relevant sections of the ITR form. The investor needs to give the name of the mutual fund scheme, the amount of investment, the holding period, the dividend or capital gains earned, and the tax paid. If the investor has invested in multiple schemes, he/she must provide details of each scheme. You can find the details of mutual fund investments in the investor’s account statement or by accessing the mutual fund website.

Conclusion

Investing in mutual funds comes with certain risks, but it can be a safe investment option if you do it correctly. Professionals manage mutual funds. By investing in mutual funds, investors can benefit from the potential returns of the stock market while mitigating the risks through diversification. Doing thorough research before investing in any mutual fund scheme is important.

FAQs

How much tax do I pay on mutual funds?

You pay tax on mutual funds based on the type of gain. Short-term capital gains are taxed at your income tax rate, while long-term capital gains are taxed at a flat rate of 10% without indexation benefit.

How much amount is tax-free in a mutual fund?

Up to Rs 1 lakh per year in long-term capital gains from mutual funds is tax-free. This rule applies from April 1, 2023, for all capital gains.

Is mutual fund SIP tax free?

Mutual fund SIP returns are subject to taxation. The tax rates vary depending on factors like the type of mutual fund and the holding period. SIP investments are not entirely tax-free.

Is mutual fund taxable in ITR?

Yes, mutual fund gains are taxable and must be declared in your Income Tax Return (ITR). The tax rates vary depending on factors like the type of mutual fund and holding period.

How do I avoid tax on mutual funds?

To reduce taxes on mutual funds, consider tax-efficient funds, use strategies like tax harvesting, invest in tax-saving funds like ELSS, and utilize exemptions and deductions available in the tax laws.

Is TDS deducted on mutual funds?

Yes, TDS (Tax Deducted at Source) is deducted on mutual fund gains exceeding Rs 5,000 for resident individuals, as per Section 194K of the Income Tax Act.

Disclaimer: Investing in mutual funds is subject to market risks. Please read all scheme-related documents carefully before investing. Potential returns from a mutual fund product are not guaranteed. Past performance is not indicative of future results. None of our articles are intended to and should be considered investment/financial advice from CoinSwitch.

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