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How does Income Tax on Mutual Funds Work?

Investing in mutual funds is a tricky business to trade-in but will fetch high returns once invested in the right funds. However, mutual funds are not exempted from taxation. The income-generating from the mutual funds are subjected to either income tax or long term or short term capital gain tax depending on the nature and type of the mutual fund. The income tax rules on mutual funds solely depend on the type of mutual fund and the wealth that is being generated from it.

The investor’s portfolio plays a great role in determining the income tax slab of the investor. The dividend earned from the mutual funds, in most cases, is tax-free for the investors while the dividend distribution tax (DDT) has to be paid by the fund house at the time of declaration of the yearly dividend. Capital gains refer to the return earned from the mutual fund at the time of sale of those funds.

Types of Holding Periods

The mutual funds capital gains taxation solely depends on the type of mutual fund scheme and the investment tenure chosen. The capital gain from mutual funds can be categorized in long term capital gain and short term capital gain based on the tenure. For equity funds, returns on investments made for less than 1 year are considered as short term capital gain and returns on investments made for more than 1 year are known as long term capital gain. The taxation on such mutual funds is subjected to Long Term Capital Gain (LTCG) tax and Short term Capital Gain (STCG) tax. Most of the equity, debt, and balanced mutual funds are subjected to income tax on mutual funds in India. The taxation on mutual funds is discussed below as per its categorization.

Long-Term Holding Period

When it comes to equity mutual funds, a holding period of 12 months or more is considered as ‘long term’. However, for debt funds, the investment is considered long term if the holding period is more than 36 months.

Short-Term Holding Period

Equity investments are regarded as ‘short term’ if the holding period is less than 12 months. Debt funds held for less than 36 months are considered as short term.

Taxation on mutual funds

Since the taxation of mutual funds is solely based on the type of mutual fund, let us discuss the income tax on mutual funds on the basis of the kinds of mutual funds.

Dividends from both equity mutual funds and debt mutual funds are tax-free until it reaches the investors. However, these dividend payouts happen once the fund house has paid the dividend distribution tax (DDT). Dividend distribution tax on mutual funds includes a 12% surcharge and a 4% cess.

Equity mutual funds are subject to DDT of 11.64% and debt mutual funds are subject to DDT of 29.12%

For instance, if you hold a total of 1000 units in a fund and if the fund declares a dividend of Rs. 2 per unit, you will receive Rs. 2000 as a dividend payment.

Mutual Funds Dividends Taxation for FY 2020-2021

Dividend is a part of the profit earned by the company which is distributed amongst its investors. Dividend Distribution Tax (DDT) is a liability that a company must pay to the government according to the dividend paid to the company’s investors.

As of FY 2019-20, DDT is payable to the government but not by the investor, instead, the fund house managing the mutual fund will pay it. In most schemes, the DDT rate is around 30%. However, according to the budget for FY 2020-21, Dividend is taxable at the hands of the investor and not the fund house. Hence, as it implies that DDT has been abolished under the new tax regime.

Mutual Funds Capital Gains Taxation for FY 2019-2020

Short term Capital Gains Tax

Type of Funds Holding Period Tax Rate
Equity Funds Up to 12 months 15%
Non-Equity Schemes Up to 36 Months Income tax slab rate of the investor

 Long term Capital Gains Tax 

Type of Funds Holding Period Tax Rate
Equity Funds More than 12 months 10%
Non-Equity Schemes More than 36 months 20% after indexation

Equity Funds

The investors who have invested in equity funds and have planned to remain invested in those plans for more than 1 year are taxed 10% on the long-term capital gain. However, it should be noted that this tax rate is applicable only if the gain in the given financial year is over Rs. 1 lakh. In the case of investors holding the equity mutual funds for less than 12 months, the short term capital gain is taxed at 15% on the returns. ELSS does not fall under this category and will be discussed separately later in the article.

Debt Funds

The debt funds generally have a lock-in period for 3 years. In case of sale of debt funds before 3 years, the Short term Capital Gain (STCG) tax is levied as per applicable income tax slabs of the investors. Long term capital gains of debt funds are charged an income tax of 20% with indexation. Indexation is the recalculation of the purchase and sale of the debt mutual funds taking into account the inflation rate. Hence, the debt fund investors are bound to less tax obligations due to the indexation of the capital gains.

Balanced Funds

The Balanced funds, also referred to as hybrid funds are a combination of debt and equity mutual funds. The income tax rate on the returns of the balanced fund is similar to equity funds if it is an equity-oriented hybrid fund while the taxation is similar to debt-oriented funds if it is a debt hybrid fund. Thus the income tax levied on equity-oriented hybrid funds is 10% on long term capital gain and 15% on the short term capital gain. The income tax rate on the debt-oriented hybrid funds is  20% on the profit earned after the indexation.

ELSS Mutual Funds

Equity Linked Savings Schemes or ELSS funds qualify for income tax return filing under Section 80C of the Income Tax Act, 1961. The investor of ELSS becomes eligible for tax exemption up to Rs.1.5 lakhs under 80C cap. However, this tax exemption of Rs. 1.5 lakhs is the overall income tax returns for employee provident fund (EPF) contribution (deducted by your employer), life insurance premiums, Public Provident Fund, National Savings Certificate (NSC), Senior Citizens’ Savings Scheme (SCSS), ELSS mutual funds, etc. The investors can choose ELSS mutual funds as the investment option if he aims at saving tax.

Tax Saving Mutual Funds

Apart from ELSS, there are certain mutual funds that offer tax-saving benefits. These funds are also included for the tax exemption under Section 80C of the Income Tax Act, 1961. The long-term capital gains under these schemes are not taxable. The portfolio assets of such funds are diversified so as to minimize the risk of massive losses. These funds are professionally managed by experienced fund managers having in-depth market knowledge preventing the loss of your hard-earned money invested in the tax saving mutual funds.

Mode of Investment

Apart from the types of mutual funds, the taxation of mutual funds depends on the mode of investment. The Systematic Investment Plans (SIPs) are taxed on a pro-rata basis which means every new investment in SIP is individually taxable and holding period is reckoned from the date of that investment. The returns of SIP investment made for 1 year is considered as long term capital gain and these gains are tax-free. The SIP investment in the debt funds or hybrid funds (MIPs) will be levied a tax of 20% on the capital gain after the indexation. However, it should be noted that the long term for SIP investment in the debt funds is 3 years.

Conclusion

Tax planning should be an integral part while planning about investing in mutual funds. There are very few funds that are tax-free such as bonds issued by the government, municipal bonds (munis), ELSS, etc. Hence, it is advisable to calculate the income tax to be paid for the mutual funds with a comparison to the returns to be fetched at the end of the investment tenure. Moreover, after the comparison of the tax charged on the long term and short term capital gain, it can be concluded that the longer the holding period of the mutual funds, the more tax-efficient is the mutual fund investment.

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