All You Need To Know About Taxation In Mutual Fund

All You Need To Know About Taxation In Mutual Fund

When it comes to investment in mutual funds, the second most important thing people consider is taxation; returns remain undoubtedly the first. When we say a particular investment is taxable, then it is very important to understand how it is taxed. This is because taxation is one of the things that might influence your investment decision and returns that you take home. In this article, we would try to understand how mutual funds are taxed and how should you go about the process. 

The gain or profit from mutual funds is considered as capital gain and taxed accordingly. Many a times, people get confused that if they will remain invested, they would get taxed. But that’s not the case. In mutual funds, only the realised gains get taxed. When we say realised gains, it means that the gains that arise after selling the units of mutual funds. Taxation on mutual funds is largely considered to be an intricate subject. This is because the taxes paid on mutual funds chiefly depend on various factors such as type of fund, investment tenure and which income slab you belong to. The following figure summarises mutual fund taxation.

Types of Funds

Taxation would differ depending upon the type of fund you are invested in. And since there are various kinds of funds, the Securities and Exchange Board of India (SEBI) has bucketed them into different categories depending upon their traits. However, when it comes to taxation there are three categories that we need to be aware of which we have briefly explained as below.

Equity Funds

Equity funds are those that predominantly invest their assets in equity and related instruments. Funds such as large-cap funds, mid-cap funds, small-cap funds, multi-cap funds, sectoral or thematic funds, etc. fall under equity funds. Equity funds are taxed differently and are pretty straight forward and easy to understand.

Fixed Income or Debt Funds

 Debt funds are those that principally invest in fixed income securities such as bonds, debentures, certificate of deposits, commercial papers, etc. Funds such as liquid funds, short duration funds, gilt funds, credit risk funds, dynamic bond funds, etc. fall under this category. Here the taxation is completely different than that of equity. For some investors, it might feel complex as well. However, it is not rocket science. Hence, stay tuned as we further discuss with an illustration as to how they are taxed.

Hybrid funds

Hybrid funds are those that invest in both the worlds, i.e. equity and debt. Funds like aggressive hybrid funds, conservative hybrid funds, balanced funds, dynamic asset allocation fund, balanced advantage fund, etc. fall under the hybrid category. Now when it comes to tax hybrid funds it depends on how the asset allocation is between equity and debt. If the fund is more tilted towards equity, then it is taxed like equity funds and if the fund is tilted towards debt, then it would be taxed like debt funds.

Short-Term and Long-Term Capital Gains

Now you may wonder what short-term and long-term capital gains are and how to determine their duration. Basically, this is determined with the help of duration and type of the mutual fund. The table below throws more light on the same.



Equity-oriented hybrid funds are those that have minimum 65 per cent of the assets dedicated towards equity and related instruments. Debt-oriented hybrid funds are those that have minimum 65 per cent of the assets dedicated towards debt securities.

Taxation in Mutual Funds

In this section, let us understand how the mutual funds are actually taxed. Here we will not just touch upon the capital gains tax part, but also discuss other taxation effects such as taxation in case of systematic investment plan (SIP) and how dividends from mutual funds are taxed.

Equity Mutual Funds

If you hold equity mutual funds for less than one year, then they are considered short-term capital gains (STCGs) and taxed at the rate of 15 per cent. However, equity mutual funds held above one year are considered as long-term capital gains (LTCGs). In case of LTCG, there is no tax if the gain in below Rs1 lakh. But if the gain is above Rs1 lakh then LTCG tax is applicable at the rate of 10 per cent with no indexation benefit.

This taxation is applicable to both tax-saving mutual funds and regular equity mutual funds. However, the only difference is that equity-linked saving schemes (ELSS) come with a lock-in period of three years. This means by default only LTCG tax will be applicable for ELSS, whereas most of the open-ended equity funds have no lock-in period. Note that Rs1 lakh limit is cumulative of capital gains on all equity instruments such as stocks and equity mutual funds.

Debt Mutual Funds

In case of debt mutual funds, if gains arise after three years, it is considered as LTCG and taxed at the rate of 20 per cent with indexation benefit. Indexation is nothing but a method in which inflation is factored in at the time of purchase to sale of units. So how does the indexation mechanism works? What indexation does is that it allows inflating the purchase price of debt funds which would bring down your capital gains and in turn your LTCG tax. However, for gains arising before three years, STCG tax is applicable. Here, all your STCG gets added to your overall income and is taxed as per your individual tax slab rates.

Hybrid Mutual Funds

Hybrid funds are taxed depending upon their equity exposure. If the hybrid fund is equity-oriented i.e. its equity exposure is not less than 65 per cent, then it is taxed similar to equity mutual funds and in case the equity exposure is less than 65 per cent, it is taxed as debt mutual funds. However, there are hybrid funds that behave like debt funds but enjoy tax status similar to equity funds. Those are arbitrage and equity saving funds. This can be tax-effective for people in the highest tax bracket with investment horizon of one year.

In addition to tax, as an investor, you will also have to bear the exit load while selling your mutual funds. In the case of equity funds, it is mostly one per cent, if redeemed before 365 days. In the case of debt funds, it depends upon the category of funds. For example, overnight funds and the most ultra-short duration funds do not charge mutual fund exit load. Whereas, debt funds, which follow an accrual-based investment strategy, usually charge higher exit loads.  

Systematic Investment Plan (SIP)

SIP is the way that allows investors to invest in mutual funds periodically. This comes handy when investors cannot invest lump sum amount and even helps them avoid market timing. And SIPs are taxed similar to what just we have explained above. The only difference is that while considering the duration of whether it is long-term or short-term, each SIP is evaluated. Say, for instance, you initiate a SIP of Rs20,000 a month in an equity mutual fund for 12 months.

As each SIP would be considered as a new investment, after 12 months if you decide to sell your entire accumulated units then not all your gains will be applicable for LTCG tax. Only those gains that you have earned on your first SIP would be considered LTCG and taxed accordingly. This is because only that particular SIP would have completed one year. And for the rest of the gains it would be considered as STCG and taxed at the rate of 15 per cent.

Dividend Distribution Tax

Being a mutual fund investor, you might know that there is an option known as dividend payout where you receive periodic payments in the form of dividend. However, this option is not as efficient as paying dividend is at the discretion of the mutual fund. Unlike stocks, in case of mutual funds dividend is paid from your own capital investment. That said, this is something that we can discuss some other day. But yes, these dividends get taxed.

With effect from April 1, 2020 income from dividends on mutual funds would be added to your overall income and would be taxed as per your individual income tax slab rates. Previously, the effective Dividend Distribution Tax (DDT) on equity funds was 11.65 per cent and that on debt funds was 29.12 per cent. The changes in DDT were made to lower the burden on small investors.

Conclusion

As a mutual fund investor, you should know and understand how your mutual fund investment gets taxed. And it is not a highly complicated subject. Indeed, our above article would have helped you gain more insights on how different mutual funds get taxed and what are the different taxes that investors need to pay. Taxes mean cost and every investor should try to minimise the quantum.

However, while doing so you should in no way compromise on the quality of your investments. Though the fact remains that for most retail investors taxation isn’t such a big issue. However, it is advisable not to frequently churn your portfolio as it potentially can increase your tax outgo

 

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