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What Are the Tax Implications On Mutual Funds?

The main objective of any investment is wealth creation. Mutual funds are efficient financial products that aid this objective through capital appreciation. Like all other investments, gains from mutual funds are taxable.

The tax you incur on mutual funds is based on the type of asset the fund focuses on and the holding period of your investment. However, a special kind of mutual fund–the equity-linked savings scheme or ELSS fund – can help you save taxes.

Asset categorization

Any mutual fund that invests more than 65 per cent of its corpus in domestic company shares is categorized as an equity-oriented fund for taxation purposes. Arbitrage funds that invest to take advantage of the difference in prices in the cash and derivative market are taxed as equity oriented funds provided the investment in cash market meets the criteria of minimum 65% investment in domestic company shares.

A debt fund (i.e. a non-equity oriented fund) that invests in different fixed-income securities carries a different tax rate from equity-oriented funds. International funds investing in stocks abroad, and fund-of-funds that make money through investments in various mutual funds are taxed like debt funds.

Hybrid funds are treated as equity oriented funds only if they have a minimum of 65 per cent exposure to domestic company shares. Otherwise, they are treated as debt funds.

ELSS mutual funds, though primarily invested in the stock market, are tax saving mutual funds. What sets ELSS apart from other equity oriented funds is the minimum lock-in period of three years.

If you opt for a dividend option, dividends shall be taxable in the hands of the investors and the mutual fund will deduct TDS @10% for resident investor and @20%(plus applicable surcharge and cess) for non-resident investor before payouts/re-investment. However, the Investor can claim tax credit of TDS deducted at the time of filing of their annual return

Holding periods

The duration for which you hold on to your mutual fund investment is called the holding period. Short-term investments attract a tax rate different from long-term investments.

Short-term taxation

Investment in any equity-oriented mutual fund for less than 12 months is considered short-term and attracts a short-term capital gains tax of 15 per cent.

For debt funds, a holding period of fewer than 36 months is considered a short-term investment. Short-term capital gains on debt funds are taxed according to your individual income slab.

Long-term taxation

Gains from equity mutual funds held for more than 12 months attract long-term capital gains tax at 10 per cent if the total long term capital gains amount from equity oriented mutual funds/ equity shares exceed ₹1,00,000 in a year. Returns below that threshold are tax-free.

Gains from debt funds, on the other hand, are taxed at 20 per cent after indexation benefit, if held for over 36 months. Indexation refers to gains adjusted for inflation. Without indexation, the tax on debt funds would be higher.

Tax saving mutual funds

When you invest in an ELSS fund, you are eligible for a tax deduction. You can save up to ₹1,50,000 under Section 80C of the Income Tax Act, 1961. Although primarily an equity fund, the lock-in period of three years and the high probability of return makes it one of the best tax saving options available to investors.

Snapshot: Taxation on mutual funds

Asset type

Details

Short-term capital gains

Long-term capital gains

Equity funds

Arbitrage funds

Balanced funds (65%+ in domestic equity shares)

Holding Period

Up to 12 months

Over 12 months

Tax Rate

15%

10%*

Debt funds

International funds

Fund of funds

Holding Period

Up to 36 months

Over 36 months

Tax Rate

Income Tax Slab Rate

20% after indexation

*Gains up to ₹1,00,000 per annum are tax-exempt.

Securitiestransaction tax

Apart from the taxes mentioned above, all equity-oriented funds also incur a securities transaction tax of 0.001 per cent at the time of redemption. Investors receive the fund after STT deduction, so you do not have to pay it separately.

SIP taxation

Tax on systematic investment plans is calculated for each individual unit. The holding period from the date of purchase to the redemption date determines whether it will be considered for short-term or long-term capital gains tax. If redemption is carried out in parts, then the first-in, first-out rule is applied, meaning that the first units purchased are considered sold first.

Things to remember

  • Mutual funds are taxed based on asset categorization and duration of the investment.
  • Equity oriented mutual funds have a short-term capital gains tax of 15 per cent for a holding period of up to 12 months. Beyond that, long-term capital gains tax of 10 per cent is applicable for gains (from equity oriented mutual funds and equity shares) over ₹1,00,000.
  • Debt mutual funds are taxed as per your income slab for investments held for up to 36 months. After that, long-term capital gains tax of 20 per cent applies, after adjusting for inflation.
  • Equity-linked savings schemes are eligible for tax deduction up to ₹1,50,000 per annum
  • Dividends are taxable in the hands of investors.
  • TDS @10% for resident investor and @20%(plus applicable surcharge and cess) for non-resident investor shall be deducted by the mutual fund on dividend distributed

Conclusion

Despite taxation, mutual funds can help you reach your financial goals with careful planning. Holding funds for the long haul makes them more tax-efficient. Account for tax when you calculate your returns.

Next To Come: Mutual Funds vs Fixed Deposits