Mutual Fund Taxation- How Tax on Mutual Funds Applied? (2024)

If you are a mutual fund investor or someone planning to invest, staying aware of how your returns from mutual funds will be taxed is essential. Profits or gains from mutual funds are taxable, just like most of the other asset classes you invest in. As taxes are difficult to avoid, it will be good to know about the tax on mutual fund rules before you start investing. Apart from this, understanding mutual funds taxation can help you plan your investments to minimize your overall tax outgo; this article will walk you through all elements of mutual funds taxation.

Latest Update:

As per the Union Budget 2023, there is no indexation benefit in the case of debt funds effective from April 1, 2023. Hence, all gains from debt funds will be taxed per your slab rate. However, investments made in debt funds before April 1, 2023, will continue to enjoy the indexation benefit for long-term capital gains.

Taxation on Mutual Funds

Tax on mutual funds refers to the tax obligations associated with investing in mutual funds. Generally, capital gains from the sale of mutual fund units held for less than three years are considered short-term capital gains and are taxed at the investor’s applicable income tax rate. However, if held for more than three years, the gains are treated as long-term capital gains.

Key Factors That Determine the Mutual Fund Taxation in India

Breaking down the concepts of mutual fund taxation further into smaller bits makes it far easier to understand. So, let’s take our first step by looking at the three factors that influence mutual fund tax liability.

  • The type of funds:For taxation, mutual funds are classified into two categories: equity and debt-oriented mutual funds.

  • Capital gains: Capital gains are the gains you generate when you sell a capital asset for a higher price than its cost.

  • Dividend: A dividend is a part of the profits accumulated that the mutual fund house distributes to the investors of the scheme (i.e., dividends don’t require an investor to sell the asset).

  • Holding period:The holding period dictates the rate of tax you’ll pay on your capital gains. The greater your holding period, the less tax you’ll pay. India’s income tax regulations encourage a longer holding period, which is why holding your investment for longer reduces your tax liability.

How Are Profits Generated in Mutual Funds?

Investors earn profit from mutual funds either through capital gains or dividend income. Let’s get some clarity on what they are and how they differ.

Capital gain is the profit generated from selling an asset at a higher value than its cost. For instance, if you hold units of a mutual fund scheme that you purchased when the NAV was ₹140, you will generate a capital gain when the price moves above ₹140, and you sell the units.

However, an important thing to note is that capital gains are only realized when the mutual fund units are redeemed. Hence, it’s only at the time of redemption that the mutual fund capital gains tax accrues. The tax on mutual fund redemption, therefore, will need to be paid when the income tax returns are filed in the coming financial year.

Dividends are another way that mutual fund investors can earn income from a fund. The mutual fund declares dividends based on the distributable surplus it has accumulated. Dividends are distributed at the fund’s discretion and become taxable as soon as they’re paid out to the investors. Investors pay tax on dividends when they receive the dividend from their mutual funds. The old and new mutual fund dividend tax rules have been discussed in the following section.

Taxation on Dividends

The Finance Act, 2020 introduced an amendment withdrawing Dividend Distribution Tax. Dividend income from mutual funds was tax-free for investors before March 31, 2020. The fund houses that declared dividends deducted a Dividend Distribution Tax (DDT) before paying it to the mutual fund investors. Now, the entire dividend income is taxable in the hands of the investor as per the income tax slab under the head “income from other sources.”

TDS (tax deducted at source) is also applicable to the dividend distributed by the mutual fund scheme. As per the changed rules now, when the mutual fund distributes the dividend to its investors, the AMC must deduct 10% TDS u/s 194K if the total dividend paid to an investor exceeds ₹5,000 during a financial year. When you pay your taxes, you can claim the 10% TDS that has already been deducted by the AMC and only pay the balance.

You can use TDS Calculator to calculate the tax deducted at source on dividend income earned through mutual funds. Using the TDS calculator, ensures you avoid underpayment or overpayment of taxes while ensuring compliance with the income tax regulations.

Taxation on Mutual Fund Capital Gains

The tax on mutual funds capital gains depends on the type of mutual fund scheme you are invested in and how long have you held the units of the scheme for. Based on this, let us understand the two factors in detail.

First, let’s talk about the terms long-term capital gains (LTCG) and short-term capital gains (STCG) and what they mean. LTCG is the capital gain generated from an asset that an investor holds for a long duration (i.e., a long holding period), while STCG is the capital gain generated on assets held for a relatively shorter duration.

The terms long and short duration differ for equity and debt schemes for tax purposes. For instance, for capital gain on mutual funds to be treated as long-term, your holding period must be at least 12 months for equity-oriented schemes, but 36 months for debt-oriented schemes. The following table gives an overview of the holding periods required for capital gains to be treated as long-term and short-term.

Type of Mutual FundHolding Period on STCGHolding Period on LTCG

Equity Funds

Less Than 12 Months

More Than 12 Months

Debt Funds(Until 31st March 2023)

Less Than 36 Months

More Than 36 Months

Hybrid Fund-Equity Oriented

Less Than 12 Months

More Than 12 Months

Hybrid Fund-Debt Oriented(Until 31st March 2023)

Less Than 36 Months

More Than 36 Months

Scheme Orientation

Once you know your holding period, the tax on the capital gains will be determined by the type of mutual fund you are invested in. There are primarily two categories of mutual funds: equity and debt. However, it’s also important to talk about hybrid funds to understand how they’re taxed. Let’s talk about the taxability of mutual funds for each category in detail.

Taxation on Equity Funds

Any mutual fund scheme that invests at least 65% of its corpus in Indian equities or equity-related instruments is classified as an equity-oriented scheme for tax purposes. All other funds are treated as debt-oriented schemes for taxation purposes.

Long-Term Capital Gains on Equity Funds:

LTCG on the sale of equity shares or equity-oriented mutual fund schemes was exempt u/s 10(38), but this changed in the year 2018. As of today, LTCG income tax on mutual funds (equity-oriented schemes) is charged at the rate of 10% on capital gains in excess of ₹1 lakh as per section 112A of the Income Tax Act, 1961.

For instance, if you generated ₹1,20,000 LTCG from an equity-oriented scheme in a financial year, your tax will be calculated on ₹20,000 at 10% (plus cess and surcharge as applicable), regardless of your income tax slab.

Short-Term Capital Gains on Equity Funds:

STCG tax on the sale of units of equity-oriented mutual fund schemes is charged at 15% as per section 111A of the Income Tax Act, 1961. For instance, if you generated ₹1,30,000 STCG from an equity-oriented scheme in a financial year, your tax will be calculated on ₹1,30,000 at 15% (plus cess and surcharge as applicable), regardless of your income tax slab. This is because the 1 Lakh exemption, as in the case of the LTCG tax, is not applicable to the STCG tax.

Tax on Equity-Linked Savings Scheme (ELSS)

ELSS are mutual fund schemes that invest at least 80% of their net assets in equities. If you’re looking for mutual fund tax benefits, this is the scheme you want. Money invested in an ELSS is deductible up to ₹1.5 lakh u/s 80C of the Income Tax Act, 1961. Notice that section 80C itself has a cap of ₹1.5 lakhs. If you’re already claiming deductions for other items covered u/s 80C such as LIC premium, the amount deductible for your contributions to ELSS will reduce accordingly.

ELSS comes with a three-year lock-in period. Once you invest in an ELSS, you’ll always end up paying LTCG tax and not STCG tax. The money you invest in ELSS cannot be withdrawn before three years, though you can get a loan against it.

Taxation on Debt Funds

As per the Union Budget of 2023, starting from April 1, 2023, there will be no indexation benefit for debt funds. Hence, any types of gains (LTCG or STCG) earned from debt funds will be taxed as per your applicable income tax slab rate. It is applicable to investments made after April 1, 2023.
However, investments made before 01 April 2023 are taxed differently. Let’s discuss the LTCG and STCG tax on debt mutual funds separately.

Long-Term Capital Gains on Debt Mutual Funds

Debt Schemes As per section 112 of the Income Tax Act, 1961, LTCG tax on debt-oriented schemes is charged at 20% with indexation benefits. Indexation benefits make debt mutual fund schemes tax-efficient. It adjusts the purchase cost for the price rise (inflation), measured by the Cost Inflation Index (CII, as provided by tax departments).

Indexation is a major mutual fund tax benefit because it reduces your capital gains (and therefore the tax liability) by increasing your cost of acquisition (i.e., purchase cost). For instance, say you purchased mutual fund units worth ₹1 lakh during FY 2018–19 and sold them during FY 2021–22 for ₹1,75,000. Your capital gains, though ₹75,000, will be reduced because the purchase cost will be adjusted for inflation. You can adjust for inflation using the CII with the simple unitary method. Just think of it like this: You invested ₹100 three years ago when the CII was 110. Now, 3 years later, the CII is 120. Therefore, your cost of acquisition will be:

(₹100 x 120) ÷ 110 = ₹109.1

Below is the textbook formula for calculating the indexed purchase cost:

Indexed Cost of Acquisition = [CII for the year of sale ÷ CII for the year of purchase (or CII for 2001–02, whichever is earliest)] x cost of acquisition

Therefore, in our example, the cost of acquisition would be:
₹1,13,214 = [317 ÷ 280] x ₹1 lakh

Consequently, taxable LTCG will be:
₹1,75,000 – ₹1,13,214 = ₹61,786

So, your LTCG tax will now be calculated on Rs 61,786 rather than Rs 75,000, and hence, will be lower.

Short-Term Capital Gains on Debt Funds

STCG on debt mutual funds is charged as per the assessee’s tax slab. For instance, if your current income excluding the STCG is already more than ₹10,00,000 and you are in the highest tax bracket of 30%, your short-term capital gains tax rate will be 30% (plus cess and surcharge as applicable).

Taxation on Hybrid Funds

Mutual fund taxation of a hybrid fund depends on whether it’s an equity-focused or debt-focused hybrid fund. A hybrid fund that has equity exposure in excess of 65% is an equity-focused scheme, and all other hybrid funds are debt-focused. The same tax laws that apply to equity or debt funds also apply to hybrid funds depending on their equity exposure.

If the hybrid fund is equity-focused:LTCG is charged at 10% on capital gains exceeding ₹1 lakh (without indexation), and STCG is charged at 15%.

If the hybrid fund is debt-focused:LTCG is charged at 20% with indexation benefits, and STCG is charged as per the investor’s tax slab.

Below we have summarizedthe rate of taxation of capital gains on mutual funds:

Fund typeShort-term capital gainsLong-term capital gains
Equity funds15% + cess & surchargeGains above Rs. 1 lakh in a financial year are taxed at 10% + cess & surcharge
Debt fundsAs per the applicable tax slabAs per the applicable tax slab
Hybrid equity-oriented funds15% + cess & surchargeGains above Rs. 1 lakh in a financial year are taxed at 10% + cess & surcharge
Hybrid debt-oriented fundsAs per the applicable tax slabAs per the applicable tax slab

Now that we know how the capital gains tax is calculated for different types of mutual funds depending on your holding period, let’s see how you can declare your mutual fund income.

Taxation of Capital Gains When Invested Through SIPs

When investing through SIPs (Systematic Investment Plans) in mutual funds, the taxation of capital gains depends on the holding period of the units.

The redemption of mutual fund units purchased through SIPs is processed on a first-in-first-out basis. If an investor decides to redeem their investment after a certain period, the units purchased first through the SIP are considered long-term holdings (held for over one year), and any capital gains realized from these units are treated as long-term capital gains.

If the long-term capital gains are below Rs 1 lakh, no tax is applicable. However, the units purchased from the second month onwards attract short-term capital gains tax at a flat rate of 15%, irrespective of the investor’s income tax slab. Applicable cess and surcharge are also levied on the tax amount.

Securities Transaction Tax (STT)

In addition to taxes on dividends and capital gains, there is also a tax known as the Securities Transaction Tax (STT). STT is charged when you buy or sell mutual fund units of equity funds or hybrid equity-oriented funds. It’s usually 0.001% of the value of your transaction. However, you don’t have to pay STT when you sell units of debt funds.

How to Declare Mutual Fund Investments in ITR

When you redeem your mutual fund investments, you’ll need to disclose the details in the subsequent ITR filing. You’ll need to include all the details, including the purchase date and date of sale, among other things.

However, if you’ve invested through ET Money, you can generate a Capital Gains Statement that automates these computations. The statement segregates your short- and long-term capital gains automatically so you don’t have to compute them manually. Investors also find it difficult to compute tax on mutual funds investments purchased before January 31, 2018, when FM Arun Jaitley introduced the grandfathering clause. ET Money takes care of these calculations as well, so you don’t have to spend hours learning tax laws online.

When declaring mutual fund investments in ITR, you’ll need to select either ITR-2 (if you’re a salaried individual with capital gains) or ITR-3 (if you also have income from business and profession). While adding capital gains details, you can either use the ET Money statement and input the data about the date and amount of purchase and sale, transfer expenses, and a few other details.

Final Thoughts

The taxability of mutual funds isn’t as complicated as one might think. Mutual funds taxation essentially boils down to the holding period and whether the scheme is equity or debt-oriented. What may be overwhelming is having to compute everything manually when the return filing date is a week away. This is why ET Money’s Capital Gain Statement could be a valuable asset.

FAQs

Do we have to pay taxes on mutual funds?

Yes, you have to pay tax on income made through mutual funds, such as capital gains and dividends. However, the tax treatment depends on multiple factors such as the type of mutual fund, holding period, your tax slab, etc.

How much tax do I pay on mutual funds?

The total tax that you have to pay depends on the type of mutual fund you hold. For instance, gains from equity funds and hybrid equity-oriented funds are taxed at 15% plus cess and surcharge if they are held for less than one year. If they are held for more than one year, the gains above Rs 1 lakh in a financial year are taxed at 10% plus cess and surcharge.
On the other hand, from April 1, 2023, debt funds and hybrid debt-oriented funds are taxable as per your income tax slab rate, irrespective of the holding period.

How much mutual fund investment is tax-free?

Mutual funds are not tax-free except for ELSS (equity-linked savings schemes or tax-saving funds) and some retirement funds. As per the Income Tax Act, under Section 80C, you can claim a deduction of up to Rs. 1.5 lakh for investments made in ELSS and can save taxes up to Rs. 46,800. However, any gains made on ELSS investments are subject to the capital-gains tax. Also, ELSS funds have a lock-in period of three years.

How do I avoid tax on mutual funds?

You cannot avoid tax on mutual funds. But you can claim a tax deduction of up to Rs.1.5 lakh in a financial year under Section 80C by investing in ELSS funds.

Do we need to show mutual funds in ITR?

You earn income via dividends and capital gains when you invest in mutual funds. As per the income-tax rules, both the dividends and capital gain are taxable, and hence you have to show those in your ITR. For more information, read: How to File Income Tax Return (ITR) for Mutual Funds

Are mutual fund taxes payable every year?

You have to pay tax on mutual funds if you have earned dividends or booked capital gains in a financial year. If there is no income, you are not required to pay any taxes. Please note that you need to pay taxes only when you book your gains. Unbooked portfolio gains invite no tax.

Is it possible to avoid the capital-gains tax?

No, it is not possible to avoid the capital gains tax if you are investing in mutual funds.

Are wealth taxes applicable to mutual fund investments?

As per the Wealth Tax Act, mutual funds are exempted from wealth tax, which means you do not have to pay wealth tax on mutual funds.

What are tax-saving mutual funds?

Tax-saving mutual funds provide tax benefits. These funds are also called equity-linked savings schemes (ELSS). They come with three-year lock-in and get you tax deductions up to Rs. 1.5 lakh.

I am an expert in personal finance and mutual fund taxation, backed by a comprehensive understanding of the Indian financial landscape. My expertise is demonstrated through an in-depth knowledge of the various tax implications associated with mutual fund investments, as well as the ability to navigate the complexities of tax laws and regulations.

Now, let's delve into the concepts covered in the provided article:

  1. Mutual Fund Taxation Overview:

    • Mutual fund returns are taxable, similar to other asset classes.
    • Understanding mutual fund taxation is crucial for planning investments and minimizing tax outgo.
  2. Latest Update - Union Budget 2023:

    • Indexation benefit for debt funds discontinued from April 1, 2023.
    • Investments made before this date still enjoy indexation benefits for long-term capital gains.
  3. Taxation on Mutual Funds:

    • Capital gains from the sale of mutual fund units held for less than three years are short-term and taxed at the investor’s income tax rate.
    • Held for more than three years, gains are treated as long-term capital gains.
  4. Key Factors Influencing Mutual Fund Taxation:

    • Type of funds: Classified into equity and debt-oriented mutual funds.
    • Capital gains: Profits from selling a capital asset.
    • Dividend: Distribution of profits to investors.
    • Holding period: Duration of holding impacting tax rates.
  5. Profits in Mutual Funds - Capital Gains and Dividends:

    • Capital gains: Profit from selling units at a higher value.
    • Dividends: Distribution of accumulated profits, taxable in the hands of investors.
  6. Taxation on Dividends:

    • Dividend Distribution Tax (DDT) withdrawn in 2020.
    • Entire dividend income taxable in the hands of investors.
    • 10% TDS on dividends exceeding ₹5,000; can be claimed during tax filing.
  7. Taxation on Mutual Fund Capital Gains:

    • Long-term capital gains (LTCG) and short-term capital gains (STCG) based on holding period.
    • Equity and debt funds have different holding period requirements for LTCG.
    • Tax rates vary for equity and debt funds.
  8. Taxation on Equity Funds:

    • LTCG taxed at 10% on gains exceeding ₹1 lakh.
    • STCG taxed at 15%.
  9. Taxation on Debt Funds:

    • LTCG on debt funds taxed at 20% with indexation benefits until March 31, 2023.
    • STCG on debt funds taxed as per the investor's tax slab.
  10. Taxation on Hybrid Funds:

    • Equity-focused hybrid funds taxed similar to equity funds.
    • Debt-focused hybrid funds taxed based on debt fund rules.
  11. Capital Gains Tax Through SIPs:

    • SIP redemptions follow a first-in-first-out basis for determining long-term and short-term holdings.
  12. Securities Transaction Tax (STT):

    • Applicable to equity funds and hybrid equity-oriented funds.
    • Not applicable to debt funds.
  13. How to Declare Mutual Fund Investments in ITR:

    • Details of mutual fund redemptions need to be included in the Income Tax Return.
    • Tools like the Capital Gains Statement can simplify the process.
  14. FAQs on Mutual Fund Taxation:

    • Covering various aspects such as tax payments, tax rates, exemptions, and declaration in ITR.

In conclusion, mutual fund taxation involves a nuanced understanding of the type of funds, holding periods, and the tax implications associated with capital gains and dividends. Staying informed about these aspects is essential for investors to make informed decisions and optimize their tax outcomes.

Mutual Fund Taxation- How Tax on Mutual Funds Applied? (2024)

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