Income Tax on Mutual Funds – How Mutual Funds Are Taxed?

Planning to invest in mutual funds(MF)? Excellent choice! But, without taking tax into consideration? Since taxation will affect your cash flow, knowing the ins-and-outs of it becomes imperative. This guide will teach you all you need to know about the taxation angle of MFs.

Understanding How Mutual Funds are Taxed

Amendments made to the Union Budget 2020 have made any MF scheme taxable in a classical manner. Meaning, the dividends investors receive are added to their taxable income and then taxed as per their respective income tax slab rates.

However, the taxation of MFs depends upon the fund type and the holding period. The short-term and long-term capital gains are taxed at different rates.

What are the Factors that Determine Tax on Mutual Funds?

Tax on mutual funds depends on factors such as the type of mutual fund, the holding period, and dividend income. Here’s how these factors affect taxation-

1. Type of fund- Equity and debt mutual funds have different tax rules. Equity funds typically have a shorter holding period for tax benefits compared to debt funds.

2. Capital gains- The profit you earn when selling mutual fund units affects your tax. These gains are classified as long-term or short-term based on how long you hold the investment.

3. Dividends- Dividends, a share of the fund’s profits, are taxable. Unlike capital gains, you don’t need to sell your units to earn dividends, but they are added to your taxable income.

4. Holding period- The length of time you stay invested plays a significant role. A longer holding period often attracts lower taxes due to favourable long-term capital gains rates.

How Are Profits Generated in Mutual Funds?

Mutual funds provide returns in two forms: dividends and capital gains. Dividends are paid from the company's profits. When companies have extra cash, they may distribute it to investors as dividends. The amount received depends on the mutual fund units held by the investor.

Capital gains represent the profit investors earn when they sell mutual fund units at a price higher than the purchase price. In simple terms, capital gains occur due to an increase in the value of mutual fund units over time.

Both dividends and capital gains are taxable. Investors need to pay taxes on these returns based on the applicable tax rules, making it important to understand the tax implications while investing in mutual funds.

Taxation on Dividends

Earlier, dividends from mutual fund schemes were tax-free for investors as companies paid Dividend Distribution Tax (DDT) before distributing dividends. This meant investors did not have to include dividend income in their taxable income.

However, with the amendments introduced in the Union Budget 2020, the taxation of dividends changed. Now, dividends received by investors are added to their total taxable income and taxed according to their income tax slab rate.

This shift in taxation has transferred the responsibility of paying taxes on dividends from companies to investors. As a result, investors must now include dividend income when calculating their tax liability, which varies based on their applicable income tax slab.

Taxation of Equity Funds Capital Gains

Short-term capital gains on equity funds within a 1-year holding period are taxed at a flat rate of 15%, regardless of your income tax slab. Long-term capital gains (LTCG) up to Rs. 1 lakh are non-taxable. Anything exceeding this amount attracts an LTCG tax at the rate of 10% (without indexation).

Additional Read: 5 Tips to grow your wealth while saving taxes

Taxation of Debt Funds Capital Gains

Short-term capital gains on debt funds within a three-year holding period are taxed in a classical manner. Furthermore, a flat rate of 20% after indexation is taxable on long-term capital gains. Plus, applicable cess and surcharges are also levied on the tax.

Taxation of Hybrid Funds Capital Gains

Taxation of hybrid funds capital gains depends upon the equity exposure of the portfolio. If over 65% of the funds’ assets are invested in equity funds, then the taxation rules of equity funds apply.

Similarly, if the hybrid fund is a debt-oriented fund, the taxation rules of a debt fund apply.

Taxation of Capital Gains received from SIP investment

For investment through SIPs, you need not pay any tax on long-term capital gains less than Rs. 1 lakh. However, short-term capital gains are taxable at a flat rate of 15%, irrespective of your income tax bracket. Cess and surcharges will also apply.

The first step to calculating MF taxation is finding out the capital gains. Here’s how to calculate capital gains on mutual funds -

Buying price of the fund – selling price of the fund = capital gains

How to Calculate Long-term Capital Gains on Mutual Funds

To calculate long-term capital gains, use the following formula –

Full value of accrued or received consideration – (indexed cost of acquisition + indexed cost of improvement + cost of transfer)

Securities Transaction Tax or STT

Securities Transaction Tax or STT is a tax levied by the government on the buying and selling of certain securities, including equity mutual funds and hybrid equity-oriented funds. For mutual funds, an STT of 0.001% is charged when you buy or sell units of equity funds or hybrid equity-oriented funds. This tax is applied at the time of the transaction. However, no STT is levied on the sale of debt fund units, making them exempt from this specific tax.

How to show Mutual Fund in Income Tax Return

If you are a salaried individual, you need to file ITR-2 and if your income source is your business, you need to file ITR-3. You will be required to disclose details such as date of sale and purchase, sales consideration, purchase amount, among others.

Additional Read: ELSS: Wealth Creation Analysis

Over to you

Finally, mutual fund units become more tax-efficient the longer you hold onto them. However, do you have a different investment horizon in mind? Based on your investment goals, risk profile, and more requirements, you can compare MF schemes from the comfort of your home using Tata Capital’s Moneyfy app. Start investing today!

FAQs

Which type of mutual fund is best in India?

The best mutual fund depends on financial goals and risk tolerance. Equity funds are for growth, debt funds for stability, ELSS for tax savings, and ETFs for diversification. Investors must evaluate their needs before selecting a fund.

Which is better: FD or mutual fund?

FDs offer fixed returns with low risk, which is suitable for conservative investors. Mutual funds, on the other hand, provide higher potential returns but come with market risks. The choice depends on financial goals and risk appetite.

What is the safest mutual fund?

Overnight and liquid funds are the safest. Overnight funds invest in securities maturing in a day, minimizing risks. Liquid funds focus on short-term debt instruments with maturities of up to 90 days, reducing credit and interest rate risks.

Which type of mutual fund gives the highest return?

Equity funds, especially small-cap and mid-cap funds, offer the highest return potential. However, they come with higher risks and volatility. It is important to consider risk tolerance and investment duration before investing.

How much do you need to start investing in large-cap funds?

Large-cap funds usually require minimum lump sum investments of ₹500 to ₹1,000. SIPs may start as low as ₹100. The exact requirement depends on the fund’s policy.

What is the maximum you can invest in a mutual fund?

There is no upper limit for mutual fund investments. SIPs and lump sums can be made freely. However, some fund houses might impose limits on specific schemes, but other alternatives remain available.

Which mutual fund gives monthly returns?

Systematic Withdrawal Plans (SWPs) allow fixed monthly withdrawals from mutual funds. Dividend-paying funds may also provide regular payouts, but dividends are not guaranteed and depend on fund performance.