We all invest in mutual funds to earn income in the form of interest, dividends or capital gains. These investment incomes attract Income Tax. The taxes on mutual funds gains largely depends on the type of mutual fund you have selected and the time for which you stay invested in the respective schemes. This period of staying invested is known as the holding period of mutual funds and broadly it can be short-term or long-term.
Long-Term Holding Period- In the case of equity mutual funds and balanced mutual funds, the holding period of 12 months or more is regarded as long-term and therefore attracts long-term capital gains tax or LTCG. On the other hand, a holding period of 36 months or more is regarded as long-term for debt funds.
Short-Term Holding Period - A holding period of less than 36 months for debt funds and less than 12 months for equity and balanced funds are defined as short-term. Therefore, short-term capital gains tax is applied to their income.
Now, we can discuss about the taxes applicable for holding the different types of mutual funds for a particular period.
Taxes on Debt Mutual Funds
Before discussing the taxes on debt mutual funds, we must understand the concept of indexation.
What is Indexation?
Indexation is a method of factoring in the effect of inflation during the period of your holding the debt fund units. It is the process of adjusting the capital gain as per the cost inflation index (CII) in order to reduce the tax. It is applicable only to Long-term capital gains earned on non-equity oriented mutual funds.
Let’s understand indexation better with the help of an example. Let’s assume we have invested Rs. 100 in a debt fund in the year 2014-15 and sold it for Rs 150 in year 2018-19. Since we held the mutual fund units for more than 3 years before selling it, the gain is long term and an LTCG tax of 20% with indexation is applicable. The CII in FY14-15 was 240 and in FY18-19, it was 280. As a result, your purchase price for tax purposes will be raised to (280/240)*100 = 116 and his taxable gain will be 150 – 116 = 34. The tax payable will be 20% of 34 = Rs. 6.8 and not Rs. 10 (20% of 50).
Tax Rates for gains in Debt Mutual Funds
Returning to the taxes on the debt funds, long-term capital gains on debt funds are taxed at the rate of 20% after indexation. In debt funds, long-term implies a holding period of the fund units for more than 3 years. Short-term capital gains are earned when one sells the units before completing 3 years from the date of purchase. Short term capital gains on debt mutual funds are taxed as per the income tax slab that the investor falls under.
Taxes on Equity Mutual Funds
Equity-Linked Saving Scheme (ELSS) are diversified equity mutual funds and invest in equity shares of companies across market capitalization. They are the most efficient tax-saving instruments ideal for investors who want to save tax on their regular income. For example, let's say Mr. Shah earns Rs. 6.5 lakhs in the previous financial year. This means his income falls in the 20% income tax slab. By investing Rs. 1.5 lakh in ELSS, Mr. Shah gets a deduction under Section 80(C) of the Income Tax Act. Now his taxable income falls to 5 lakhs which comes under the 5% income tax slab. He manages to save a significant amount of his income.
ELSS comes with a lock-in period of 3 years. This means that one cannot redeem his/her units before the expiration of 3 years from the date of investment. This is one drawback of investing in an ELSS. After redemption, the long-term capital gains (LTCG) of up to Rs 1 lakh are tax-free in your hands. LTCG in excess of Rs 1 lakh is taxable at the rate of 10% without the benefit of indexation.
Also Read: Best ELSS Tax Saving Mutual Funds
Non-tax Saving Equity Funds
Long-term capital gains (LTCG) on non-tax saving equity mutual funds up to Rs 1 lakh annually are tax-free and above Rs. 1 lakh, it is taxable at the rate of 10% without the benefit of indexation. On the other hand, if you redeem the mutual funds units before 12 months then there is a 15% tax on short-term capital gains.
Taxes on Balanced Mutual Funds
Balanced funds are the kind of hybrid funds, which invest at least 65% of their assets in equities. And because their major proportionate is invested in equities, their tax treatment is the same as non-tax saving equity funds.
Tax on Mutual Funds
Securities Transaction Tax (STT)
Apart from all the taxes on long-term or short-term gains discussed above, there is also something called the Securities Transaction Tax (STT).
STT of 0.025% is levied on equity mutual funds by the fund company. This will be charged on your entire investment amount at the time of you exiting the mutual fund. There is no such tax on the sale of debt fund units.
SIP or Systematic Investment Plan is to invest a fixed amount in a mutual fund in a periodic manner. It can be weekly, monthly, quarterly or even annually. As detailed above, gains from SIPs are taxable as per the type of mutual fund and the holding period. But the interesting or unique thing about taxation on SIPs is that each installment of SIP is treated as a fresh investment and gains on it are taxed separately.
For instance, you begin the SIP of ₹1000 a month in an equity fund for 12 months. Each installment of SIP investment will be considered to be a fresh investment. Hence, after 12 months, if you redeem your entire accumulated amount (investments plus gains), all your gains will not be tax-free. Only the gains you earned on your first SIP installment would be tax-free because only that investment would have completed one year. Rest of the gains would be treated as a short-term capital gain and will be taxed accordingly.
Taxes on Dividend distribution
When you invest in dividend distributing mutual funds, you'll get taxed on the dividend income you earn. This Dividend Distribution Tax (DDT) is deducted and paid by the fund house before paying a dividend to investors. Thus, you need not pay any further taxes.
|Type of Scheme||DDT Rate|
|Equity Oriented Scheme||10%+12%Surcharge+4%Cess|
|Non-Equity Oriented Scheme||25%+12%Surcharge+4%Cess|