Tax Implications on Mutual Fund Investments

Mutual funds are one of the most buzzing investment options as they help you achieve your financial goals. Mutual funds are also tax-efficient instruments. Investing in fixed deposits is a great disadvantage, particularly if you fall under the highest income tax bracket, as the interest is added to your taxable income and taxed at your income tax slab rate. This is where mutual funds score better. When you invest in a mutual fund, you get the benefit of expert money management and tax-efficient returns.

What is Tax on Mutual Funds?

Profits gained from investment in mutual funds are known as ‘Capital gains’. These capital gains are subject to tax. So, before investing in mutual funds, you should clearly understand how your returns will be taxed. Moreover, you can also avail tax deductions in certain cases. 

Variables Determining the Taxation for Mutual Funds

1. Types of Funds: Mutual Funds are divided into two groups for tax purposes, Equity-Oriented Mutual Funds and Debt-Oriented Mutual Funds.
2. Capital Gains: When you sell a capital asset for more money than it costs to purchase, you make a profit known as a Capital Gain.
3. Dividend: A dividend is a portion of accumulated profits that the Mutual Fund house distributes to the scheme’s investors; investors do not need to sell their assets to receive a dividend.
4. Holding Period: The tax you will pay on your capital gains depends on the Holding Period. Therefore, less tax will be due if your Holding Period is longer. Because India’s income tax laws encourage longer holding times, keeping your investment longer lowers your tax burden.

How Do You Earn Returns in Mutual Funds

Mutual funds offer returns in two forms: dividends and capital gains. Dividends are paid out of the profits of the company if any. When the companies are left with surplus cash, they may decide to share the same with investors in the form of dividends. Investors receive dividends proportional to the number of mutual fund units held by them.

A capital gain is the profit realized by investors if the selling price of the security held by them is greater than the purchase price. In simple terms, capital gains are realized due to the appreciation in the price of the mutual fund units. Both dividends and capital gains are taxable in the hands of investors of mutual funds.

Taxation of Dividends Offered by Mutual Funds

As per the amendments made in the Union Budget 2020, dividends offered by any mutual fund scheme are taxed classically. That is, dividends received by investors are added to their taxable income and taxed at their respective income tax slab rates. Previously, dividends were tax-free in the hands of investors as the companies paid dividend distribution tax (DDT) before paying dividends.

Taxation of Capital Gains Provided by Equity Funds

Mutual Funds classified as equity funds have an equity exposure of at least 65%. As previously stated, when you redeem your equity fund units within a holding period of one year, you realize short-term capital gains. Regardless of your income tax bracket, these gains are taxed at a flat rate of 15%. When you sell your equity fund units after holding them for at least a year, you realize long-term capital gains. These capital gains are tax-free, up to Rs 1 lakh per year. Any long-term capital gains over this threshold are subject to a 10% LTCG tax, with no benefit of indexation.

Taxation of Capital Gains Provided by Debt Funds

Debt Mutual Funds have entirely different taxation. If a debt investment is sold within 3 years until March 31st 2023, it will be deemed as STCG. This STCG will be added to the income of the investor and would be liable to be taxed according to the tax slab under which the investor falls. If the debt investments holding period is more than 3 years, it will be termed as LTCG. It will attract an LTCG tax of 20% with indexation benefits. 

Taxation of Capital Gains Provided by Hybrid Funds

Whether a Hybrid Fund is equity-focused or debt-focused determines how the Mutual Fund taxes it. All other hybrid funds are debt-focused, while those with equity exposure over 65% are considered equity-focused schemes. Depending on how much equity exposure they have, hybrid funds may or may not be subject to the same tax regulations as Equity or Debt Funds.

Conclusion

The longer you hold on to your mutual fund units, the more tax-efficient they become. The tax on long-term capital gains is comparatively lower than the tax on short-term gains.