Tax on Mutual Funds

Mutual Funds are typically regarded as one of the most profitable investment options because they help you easily reach your
financial objectives. The fact that MFs are tax-efficient investment vehicles is one of their most significant benefits. Your investment in a
Mutual Fund may yield tax-efficient returns. However, without considering tax, you might be investing in Mutual Funds incorrectly.
Because it will impact your cash flow, an investor should consider other factors in addition to taxation, such as taxation on
dividends, redemption, etc. In addition, planning your investments to reduce your overall tax expense can be facilitated by
understanding the taxation of Mutual Funds.
This blog will walk you through every aspect of Taxation on Mutual Funds.

Taxation on Mutual Funds

Knowing how your Mutual Fund returns will be taxed is crucial if you currently invest in Mutual Funds or plan to do so in the future.
Mutual Fund gains and profits are taxable, just like those from the majority of the other asset classes you invest in. Understanding
the tax on Mutual Funds rules before you start investing will be beneficial because taxes are difficult to avoid.
You can plan your investments to reduce your overall tax expense by becoming knowledgeable about the taxation of Mutual Funds. In
some circumstances, you can also take advantage of tax deductions. So, while investing in it, stay informed of the tax on Mutual Funds
regulations.

Variables Determining the Taxation for Mutual Funds

The principles of Mutual Fund taxation are much simpler to understand when they are further broken down into smaller pieces.

So let us start by taking a look at the 4 variables that affect the tax liability of Mutual Funds:

1)Types of Funds
Mutual Funds are divided into two groups for tax purposes: Equity-Oriented Mutual Funds and Debt-Oriented Mutual Funds.

2) Capital Gains
When you sell a capital asset for more money than it costs to purchaset, you make a profitknown as a Capital Gain.

3) Dividend
A dividend is a portion of accumulated profits that the Mutual Fund house distributes to the scheme's investors; investors do not need to
sell their assets to receive a dividend.

4) Holding Period
The tax you will pay on your capital gains depends on the Holding Period. Therefore, less tax will be due if your Holding Period is
longer. Because India's income tax laws encourage longer holding times, keeping your investment longer lowers your tax burden.

How Do Mutual Funds Generate Profits?

Mutual Fund investing allows investors to profit from either Capital Gains or Dividend Income. Let us define them and examine their
differences in more detail.
Profit from selling an asset for more than its cost is known as a Capital Gain. However, it is crucial to remember that Capital Gains
are only realized upon redeeming the Mutual Fund units. As a result, the Capital Gains Tax on Mutual Funds only becomes due at
redemption. Therefore, the tax on Mutual Funds redemption must be paid when the upcoming fiscal year's income tax returns are
submitted.
Another way for investors in Mutual Funds to receive income from a fund is through Dividends. Based on its accumulated
distributable surplus, the Mutual Fund declares Dividends.
When paid to investors, Dividends are distributed at the fund's discretion and immediately subject to taxation. Therefore, when
investors receive a Dividend from their Mutual Funds, they must pay tax on it. The following section contains information on the
previous and current Mutual Fund dividend tax regulations.

- Taxation of Dividends Provided by Mutual Funds

The Finance Act of 2020 made a change that eliminated the Dividend Distribution Tax. Investors were exempt from paying taxes on
dividend income from Mutual Funds until March 31, 2020.
Dividend Distribution Tax (DDT) was deducted by the fund houses that announced dividends before paying them to the Mutual Fund
investors. The investor must pay taxes on the entire dividend income according to the income tax bracket under the heading "Income from
Other Sources."

The Mutual Fund scheme's dividend is also subject to TDS (tax deducted at source). The AMC is now required to deduct 10% TDS under
Section 194K from the dividend that the Mutual Fund distributes to its investors when the rules have changed if the total dividend paid to
an investor during a financial year exceeds ₹5,000. You can claim the 10% TDS that the AMC has already taken out when you pay your
taxes and only pay the remaining amount.

- Taxation of Capital Gains Provided by Mutual Funds

The holding period and type of Mutual Funds affect the tax rate on capital gains for Mutual Funds. The holding period is the length of
time an investor held units of a Mutual Fund. Put simply, the holding period is the time between the date of buying and selling Mutual
Funds units.

The following categories apply to capital gains realized on the sale of Mutual Fund units-
Type of Mutual Fund Holding Period on Holding Period on
STCG LTCG

Equity Funds Less Than 12 Months More Than 12 Months

Debt Funds (Until 31st March 2023) Less Than 36 Months More Than 36 Months

Hybrid Fund-Equity Oriented Less Than 12 Months More Than 12 Months

Hybrid Fund-Debt Oriented (Until 31st March Less Than 36 Months More Than 36 Months
2023)
- Taxation of Capital Gains Provided by Equity Funds
Mutual Funds classified as equity funds have an equity exposure of at least 65%. As previously stated, when you redeem your equity
fund units within a holding period of one year, you realize short-term capital gains.
Regardless of your income tax bracket, these gains are taxed at a flat rate of 15%. When you sell your equity fund units after holding
them for at least a year, you realize long-term capital gains. These capital gains are tax-free, up to Rs 1 lakh per year.
Any long-term capital gains over this threshold are subject to a 10% LTCG tax, with no benefit of indexation.

- Taxation of Capital Gains Provided by Debt Funds

Debt mutual funds have entirely different taxation. If a debt investment is sold within 3 years until March 31st 2023, it will be deemed as
STCG. This STCG will be added to the income of the investor and would be liable to be taxed according to the tax slab under which the
investor falls.
If debt investments' holding period is more than 3 years, it will be termed as LTCG. It will attract an LTCG tax of 20% with
indexation benefits.
Note indexation is applicable to only LTCG that's earned on non-equity-oriented mutual funds.
Another important thing to note is that the fund manager will levy an STT of 0.001% if you plan to sell your equity fund units. STT is not
applicable to the sale of units in debt funds.
It is essential to remember that debt funds no longer have the benefit of LTCG. The capital gains that arise from such funds will be
liable to be taxed according to the tax slab rate under which an investor falls in.

- Taxation of Capital Gains Provided by Hybrid Funds

Whether a Hybrid Fund is equity-focused or debt-focused determines how the Mutual Fund taxes it. All other hybrid funds are debt-
focused, while those with equity exposure over 65% are considered equity-focused schemes.
Depending on how much equity exposure they have, hybrid funds may or may not be subject to the same tax regulations as Equity or
Debt Funds.
- Securities Transaction Tax or STT
The Securities Transaction Tax is separate from the Capital Gains and Dividend Taxes. When you buy or sell Mutual Fund units of an
Equity Fund or a Hybrid Equity-Oriented Fund, the government (Ministry of Finance) will assess an STT of 0.001%. On the other hand,
the sale of Debt Fund units is exempt from STT.

Conclusion
In conclusion, investors can learn how Mutual Funds are taxed if they are concerned that their returns from Mutual Funds will be
reduced after paying taxes. They can determine what is advantageous for them by calculating how the tax rules for long- and short-term
investments in equity and debt funds differ.
By investing in tax-saver funds, they can reduce their tax obligations and corpus generation. Taxation for a type of fund is the same
whether it is purchased in a lump sum or through a SIP (Systematic Investment Plan). However, long-term investments may be more tax-
efficient than holding the units for a brief period.

Mutual Fund Taxation – How Mutual Funds Are Taxed?

Mutual funds are one of the most buzzing investment options as they help you achieve your financial goals. Mutual funds are

also tax-efficient instruments. Investing in fixed deposits is a great disadvantage, particularly if you fall under the highest

income tax bracket, as the interest is added to your taxable income and taxed at your income tax slab rate. This is where

mutual funds score better. When you invest in a mutual fund, you get the benefit of expert money management and tax-
efficient returns.

Latest Update:

Budget 2023: No indexation benefit will be available while calculating long-term capital gains on Specified Mutual Fund (i.e a

mutual fund which invests less than 35% of its proceeds in the equity shares of domestic companies). Debt mutual funds will

now be taxes as per the applicable slab rates.

What is Tax on Mutual Funds?

Profits gained from investment in mutual funds are known as ‘Capital gains’. These capital gains are subject to tax. So, before investing
in mutual funds, you should clearly understand how your returns will be taxed. Moreover, you can also avail tax deductions in certain
cases.
What are the Factors to Determine Tax on Mutual Funds?
Taxation on mutual funds can be explained further by pointing out the factors influencing it. Here are the essential factors that affect the
taxes levied on mutual funds:
Fund types: Taxation rules differ based on the type of mutual fund. E.g.: Equity Mutual Fund, Debt Mutual Fund, Hybrid Mutual Fund
etc.
Dividend: A part of the profit distributed amongst investors by mutual fund houses is called dividend.
Capital gains: When investors sell their capital assets at a higher price than its total investment amount, the profit is termed as capital
gains.
Holding period: Time between the date of the purchase and sale of mutual fund units. As per the income tax regulations of India, if you
hold your investment for an extended period, you will be liable to pay a low tax amount. Thus, the holding period influences the tax rate
payable on your capital gains. The higher your holding period, the lesser tax you are liable to pay.
How Do You Earn Returns in Mutual Funds
Mutual funds offers returns in two forms: dividends and capital gains. Dividends are paid out of the profits of the company if any. When
the companies are left with surplus cash, they may decide to share the same with investors in the form of dividends. Investors receive
dividends proportional to the number of mutual fund units held by them.

A capital gain is the profit realised by investors if the selling price of the security held by them is greater than the purchase price. In
simple terms, capital gains are realised due to the appreciation in the price of the mutual fund units. Both dividends and capital gains are
taxable in the hands of investors of mutual funds.

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Taxation of Dividends Offered by Mutual Funds

As per the amendments made in the Union Budget 2020, dividends offered by any mutual fund scheme are taxed in the classical manner.
That is, dividends received by investors are added to their taxable income and taxed at their respective income tax slab rates.

Previously, dividends were tax-free in the hands of investors as the companies paid dividend distribution tax (DDT) before paying
dividends.

Taxation of Capital Gains Offered by Mutual Funds

The taxation rate of capital gains of mutual funds depends on the holding period and type of mutual fund. Capital gains realised on selling
units of mutual funds are categorised as follows:
Fund Type Short-term capital gains Long-term capital gains

Equity funds Shorter than 12 months 12 months and longer

Debt funds Always short-term

Hybrid equity-oriented funds Shorter than 12 months 12 months and longer

Hybrid debt-oriented funds Always short-term

The short-term and long-term capital gains offered by mutual funds are taxed at different rates.

Taxation of Mutual Funds

Tax rates Tax Rates
(Before 31 March 2023) (After 31 March 2023)
Fund Type
Holding
STCG LTCG STCG LTCG
Period

- Equity Mutual Fund

- Arbitrage Funds 10% without 10% without
12 months 15% 15%
- Other Funds indexation indexation
(invests at least 65%in equity)

- Debt Mutual Fund (Investment in debt securities, 36 months Slab 20% with Slab Slab rate
 money market instruments, Govt. securities, corporate
bonds)
rate indexation rate
- Floater Funds (Min. 65% invested in floating rate
instruments)

- Conservative Hybrid Funds

(Equity: 10%-25% Slab 20% with Slab
36 months Slab rate
Debt: 75%-90%) rate indexation rate
- Other funds (which invest 35% or less in equity)

Other funds (invest more than35% but less than 65% Slab 20% with Slab
36 months 20% with indexation
in equity) rate indexation rate

Balanced Hybrid Funds

Slab 20% with Slab
(Equity: 40%-60% 36 months 20% with indexation
rate indexation rate
Debt: 60%-40%)

Aggressive Hybrid Funds

10% without 10% without
(Equity: 65%-80% 12 months 15% 15%
indexation indexation
Debt: 35%-20%)

Taxation of Capital Gains of Equity Funds

Equity funds are those mutual funds where more than 65% of it total fund amount is invested in equity shares of companies.
As mentioned above, you realise short-term capital gains if you redeeming your equity fund units within a one year. These gains are taxed
at a flat rate of 15%, irrespective of your income tax bracket.

You make long-term capital gains on selling your equity fund units after holding them for over one year. These capital gains of up to Rs 1
lakh a year are tax-exempt. Any long-term capital gains exceeding this limit attracts LTCG tax at 10%, without indexation benefit.

Taxation of Capital Gains of Debt Funds

Debt funds are those mutual funds whose portfolio’s debt exposure is in excess of 65% and equity exposure is not more than 35%.

Starting 1st April 2023, the debt funds will no longer receive indexation benefit and deemed to be short-term capital gain. Therefore, the
gains from debt funds will now be added to your taxable income and taxed at the slab rate.

Earlier, the long-term capital gains from debt funds were taxed at 20% with indexation benefit.

Taxation of Capital Gains of Hybrid Fund

The rate of taxation of capital gains on hybrid or balanced funds is dependent on the equity exposure of the portfolio. If the equity
exposure exceeds 65%, then the fund scheme is taxed like an equity fund, if not then the rules of taxation of debt funds apply.

Therefore, it is essential to know the equity exposure of the hybrid scheme you are investing in, if not then you might be in for a nasty
surprise on redemption of your fund units. The following table summarises the rate of taxation of capital gains on mutual funds:

Fund type Short-term capital gains Long-term capital gains

Equity funds
Any gains above Rs 1 lakh is taxed at 10% + cess +
15% + cess + surcharge
Hybrid equity-oriented surcharge
funds
 Debt funds
Investor’s income tax slab
Investor’s income tax slab rate
rate
Hybrid debt-oriented funds

Taxation of Capital Gains When Invested Through SIPs

Systematic investment plans (SIPs) are a method of investing in mutual funds. They are designed in such a way that investors can invest a
small amount periodically in a mutual fund scheme. Investors are offered the liberty to choose the frequency of their investment. It can be
weekly, monthly, quarterly, bi-annually, or annually.

You purchase a certain number of mutual fund units through every SIP instalment. The redemption of these units is processed on a first-
in-first-out basis. Suppose you invest in an equity fund through an SIP for one year, and you decide to redeem your entire investment
after 13 months.

In this case, the units purchased first through the SIP are held for the long-term (over one year) and you realise long-term capital gains on
these units. If the long-term capital gains are less than Rs 1 lakh, then you don’t have to pay any tax.

However, you make short-term capital gains on the units purchased through the SIPs from the second month onwards. These gains are
taxed at a flat rate of 15% irrespective of your income tax slab. You will have to pay the applicable cess and surcharge on it.
Securities Transaction Tax (STT)
Apart from the tax on dividends and capital gains, there is another tax called the Securities Transaction Tax (STT). An STT of 0.001% is
levied by the government (Ministry of Finance) when you decide to buy or sell mutual fund units of an equity fund or a hybrid equity-
oriented fund. There is no STT on the sale of debt fund units.
Conclusion
The longer you hold on to your mutual fund units, the more tax-efficient they become. The tax on long-term capital gains is
comparatively lower than the tax on short-term gains.

Frequently Asked Questions

Are mutual fund taxes payable every year?
If you opt for a mutual fund scheme, you need to pay the applicable taxes only when you redeem the units or sell the scheme. It does not
count on every year. However, your total income for the financial year in question includes your dividend income from mutual fund
schemes. So, you need to pay tax for this dividend income if your income is liable to income tax.

Is it possible to avoid capital gains tax?

No, you cannot avoid paying tax on capital gains; instead, you can plan your investment accordingly to be tax efficient. For instance,
taxes applicable on short-term capital gains are higher than the long-term ones. So, you need to understand the types of taxes levied on
mutual fund schemes.

What are the factors to keep in mind before choosing tax-saving mutual funds?
Though tax-saving mutual funds have certain limitations, you should consider four factors while picking one. They are mode of
investment, asset allocation, tax-exemption limits and lock-in period.

Can mutual fund investments help me get a rebate on income tax?

Under Section 80C of the Income Tax Act, tax benefits are applicable in the case of ELSS or Equity Linked Saving Schemes. You can get
up to Rs.1.5 lakh in tax deduction and save around Rs.46,800 each year on taxes. One should remember that ELSS has a minimum lock-
in period of three years.

Are wealth taxes applicable to MF investments?

According to the Wealth Tax Act, mutual funds and other financial assets are exempted from any wealth taxes. So, you need not to pay
wealth tax upon investing in a mutual fund.

What is Section 54EA regarding capital gains tax exemptions?

As per Section 54EA, a long-term capital asset that has been transferred before 1 April 2000 is invested in particular bond shares within
six months of the transfer date, then there is an exemption from capital gains as computed under Section 54F.

What are tax saving mutual funds?

ELSS are popularly known as tax saving mutual funds that can help you get deduction u/s 80C of the Income Tax Act.