Taxation on Mutual Funds – An Eye-Opener for Your Financial Planning!

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what is taxation on mutual funds

Mutual Fund Taxation – How Mutual Funds Are Taxed?

Do you have financial goals to be met in a few years? If your answer is affirmative, mutual funds are among the most interesting investment options available to you. Apart from providing wealth-generation opportunities, these financial instruments are tax-efficient as well. Of course, investing in fixed deposits is a practice that is followed for a long. But, investing in fixed deposits carries a great disadvantage. This holds particularly for people in the highest income bracket in India. The reason is that interest from fixed deposits is added to the taxable income. Then, the total is taxed at their income tax slab rate. With mutual funds, you can expect tax-efficient returns and effective money management.

Taxation on Mutual Funds

What Type of Tax Benefits You Can Get From Mutual Funds?

One factor makes mutual fund investments good. It is that the taxation on mutual funds gets into the picture only when you sell the units of a mutual fund scheme. You might wonder what other kinds of tax benefits you can get when investing in mutual funds. You can get a better idea here:

Taxes on Equity Mutual Funds:

Equity mutual funds are funds with a minimum of 65% of equity allocation in the investment portfolios. For long-term capital gains in these funds, the least holding period is one year. When you sell the units before one year, you will have to pay tax at 15% along with a 4% cess. When you sell after one year, the long-term capital gains tax percentage is 10% plus 4% cess. However, this rule applies only when the capital gain in a financial year is more than Rs. 1 lakh. The good thing here is that if the long-term capital gain is less than a lakh, it is entirely free of taxes.

For individual investors like you, the dividends you get on equity mutual funds are free of taxes. However, it is taxable at 11.648% for Asset management companies. These companies will have to pay this tax in the name of Dividend Distribution Tax.

Taxes on Debt Mutual Funds:

When it comes to debt mutual funds, the least hold period for short-term capital gains is three years. If the units are sold before these three years, the tax percentage will vary based on the tax bracket of the investor. For instance, if you come under the tax bracket of 30%, the short-term capital gains tax rate will be 30% plus 4% Cess to you. After three years, it turns out to be long-term capital gain. In this case, the tax percentage is 20% with indexation. 

What Does Indexation In Mutual Funds Mean?

Indexation is a process using which the price of acquiring mutual fund units can be inflated or adjusted. This can be done over a period to bring it to the present price after considering inflation. It gives you the option to increase the price of purchasing.

To evaluate your capital gains with indexation, you will have to index the cost at which you bought the mutual fund units. You can do this by multiplying this cost with the ratio of the cost of inflation index when you sell and the cost of inflation index of your purchasing year. Thereafter, you will have to subtract the indexed purchasing cost from the value of sales. When you invest in debt funds, indexation benefits will help with bringing down your tax obligation considerably. This is in comparison with investment in bank Fixed Deposits and other small savings schemes.

You can understand this concept better with the example below:

Mr. Akilesh invested Rs. 2 Lakhs in a mutual fund scheme in May 2016. At the time of redemption after three years, in May 2019, the investment value has turned into Rs.2.2 lakhs. So, the capital gain here is Rs.2.2-Rs.2 lakhs, which is Rs.20000. For this value, Mr. Akilesh paid a long-term capital gain. But, indexation adjusted the value of purchase of Rs.2 lakhs based on inflation. It means that the cost of purchase increases and capital gain reduces for tax purposes.

The cost of inflation index (notified values) for the year 2016-2017 and 2019-20 when the purchase and sale were made respectively by Mr. Akilesh are 264 and 289. So, the calculation is as follows:

289/264*2,00,000 = Rs/218939.3939. Now, the capital gain should be calculated as Rs.2,20,000-218939.3939 = Rs.1060.6061. So, you are not going to pay tax on the actual capital gain of Rs.20000, but, you will pay reduced tax for Rs.1060.6061 as per the example above.

Even in this case, dividends are tax-free for investors. In the case of fund houses, they are taxed as Dividend Distribution Taxes at 29.120%. 

Taxes on Hybrid Funds:

You can learn about Hybrid funds from our previous article. these funds are also called balanced funds. The tax rate on capital gains on these funds relies on the equity exposure of your portfolio. Just in case, the equity exposure is more than 65%, the fund scheme is taxed similar to an equity fund. If this does not happen, the taxation on mutual funds rules similar to debt funds apply for the hybrid fund. Here is a table to give you a better idea for different types of taxation on mutual funds investments:

Type of fund

Long-Term Capital Gain

Short-Term Capital Gain

Equity Funds Tax exemption for up to Rs.1 lakh per year. Any gains over this amount will be taxed at 10% plus cess plus surcharge 15% plus Cess plus surcharge
Debt Funds 20% plus cess plus surcharge Taxed at the income tax slab rate of the investor
Hybrid equity-oriented funds Same as equity fund 15% plus cess plus surcharge
Hybrid debt-oriented funds Same as debt fund Same as debt fund

Capital Gains Taxation when invested through SIPs:

A systematic investment plan or SIP is an investment method in mutual funds. The purpose of this investment method is to help investors to invest a small amount of money periodically in mutual fund schemes. It means that they can invest whenever they get money. They are at liberty to choose the frequency of their investment like annually, two times a year, four times a year or even 12 times a year.

Capital Gains Taxation

When you choose this investment method, you have the option to shop for a particular number of MF units in instalments. In this case, the redemption of units is calculated on a FIFO basis. Let us consider that you plan to invest in mutual funds through SIP for a year. Also, you decide that you should redeem the entire money after 13 months. In this case, the units that you shopped in the first month will be considered long-term. So, the income you gain from these units will be calculated as long-term capital gains.

If the value is less than a lakh, you need not have to pay any tax. But, the units you purchase from the second month will be considered a short-term investment. The money you gain from the sale of these units will be considered as short-term capital gains. So, these gains will be taxed at 15% flat based on your income tax slab. Also, you will have to bear the applicable surcharge and cess.