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Taxation of Mutual Funds: How mutual funds are taxed in India

Taxation on mutual funds is a complex topic. Taxes paid on your mutual fund investments vastly depend on factors such as what kind of funds you have invested in, the duration of your investment, which income tax slab you belong to and so on.

tax on mutual funds

Introduction

If you have read any of our blog posts here on Scripbox, you are no stranger to our suggestion of investing in mutual funds.

We have always suggested that mutual fund investments are a great way to get started with your investment journey.

While you carefully plan your mutual fund investments, the one variable that tends to get overlooked is the tax.

tax on debt mutual fund

Taxation on mutual funds is a complex topic.

Tax on mutual funds can get slightly confusing. Taxes paid on your mutual fund investments vastly depend on factors such as what kind of funds you have invested in, the duration of your investment, which income tax slab you belong to and so on.

Types of Mutual Funds in India

You may have heard of words like Debt funds, Equity funds, ELSS funds, being used often.

In this article, we want to discuss the topic of taxation and help you understand how your investments are taxed.

Investing in mutual funds is one of the best ways to make sure that you have enough money available for all your financial requirements for years to come. But, in order to have a clear picture of how much money your investment will fetch you at the end of the investment tenure, you also need to have a very clear idea about how much you will be paying in taxes and what kind of taxes your investments will incur.

If you ever wondered if income from mutual funds is taxable or exempt from taxes, we hope you find your answers here.

Let’s begin.

Capital Gains

When you sell your assets at a profit, the total profit earned is called a capital gain. Capital is nothing but the principal investment that was made to purchase your mutual fund units. Let’s look at an example to understand what capital gains mean.

income tax on mutual funds

Let’s assume you purchased a few units of a mutual fund for Rs. 1000. Your capital expenditure, in this case, is the principal amount of Rs. 1000. If the fund generated a return of 10%, the value of your investment is now Rs. 1100. So the capital gain on this investment is Rs. 100. Therefore, the capital gain is total income minus the initial capital.

The capital gain, Rs. 100 in this case, will be the income that is taxable.

Also, it is important to note that one incurs capital gain tax only when the asset is sold. If you continue to stay invested, you will not have to pay capital gains tax every year.

Capital gains tax depends on the mutual fund scheme and the tenure of the investment. Based on your choice of investments, you will have to pay short-term capital gains tax (STCG) or long term capital gains tax (LTCG).

We will delve into both of these momentarily. In the meantime, let’s look at how a dividend payout impacts your taxes.

Dividend Income

tax on equity mutual funds

If you invest in a mutual fund with a dividend payout option, you will receive timely payments in the form of dividends.

Whenever a dividend option mutual fund makes a profit, that profit gets distributed among investors (as per the number of units held by each investor) as dividend payments (after tax deductions).

Dividends from both equity mutual funds and debt mutual funds are tax-free in the hands of the investors. However, these dividend payouts happen after 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.

Difference Between Growth Option and Dividend Option in Mutual Funds

There is one major difference between mutual funds that offer a growth option and mutual funds that offer a dividend payout option. And that is the option of reinvesting your returns.

Growth Option

In the case of growth funds, your return on investment is automatically reinvested back into the fund. These mutual funds don’t offer any payouts in between. Over a period of time, this significantly increases the net asset value (NAV) of your investment.

Dividend Option

In the case of dividends, you can opt for dividend payout or choose to reinvest your dividends back into the fund. If you choose to receive dividend payouts, the NAV of your plan reduces to the extent of dividends paid and that reduces the overall NAV of your investment.

If you choose to reinvest your dividends, the mutual fund purchases additional units to the extent of dividends declared.

If you want to invest in mutual funds for long-term, wealth-generating purposes, growth option mutual funds are your best bet.

For this very reason, Scripbox recommends only growth option mutual funds. You can learn more about it here.

Key Factors that Determine the Taxation of Mutual Funds.

There are two important factors that determine how mutual funds are taxed in India. One of them is the type of mutual fund scheme and the other is the duration of your investment.

capital gains tax on mutual funds

Type of Mutual Fund Scheme

You might already be aware that mutual funds are broadly categorized into equity mutual funds and debt mutual funds. Since we have extensively talked about the differences between these two types of funds on our Scripbox blog, we’ll keep this bit brief.

Equity mutual funds mostly invest in equity shares and stocks trading in the stock market. Since they are subject to market volatility, they carry a higher degree of risk. You can learn more about equity mutual funds here.

Debt mutual funds, on the other hand, invest in relatively safer investment options such as government bonds, corporate bonds, etc.that offer a fixed return. You can learn more about debt mutual funds here.

Duration of Your Investment

The duration of your investment, also known as the holding period, largely determines how your taxes are calculated. The holding period of your investments can either be short-term or long-term.

In the case of equity mutual funds, an investment tenure less than 1 year (12 months) is considered short-term. Any investment over one year is considered long-term.

In the case of debt mutual funds, an investment tenure of up to 3 years (36 months) is considered short-term. Any investment over a period of 3 years is considered long-term.

Taxation of Equity Mutual Funds

If equity investments are sold under one year, the returns are treated as short-term capital gains (STCG) and taxed at 15%. Equity investments that are redeemed after one year are considered long-term capital gains (LTCG). The LTCG of up to Rs. 1 lakh is tax-free, whereas LTCG over Rs. 1 lakh is taxed at the rate of 10% without any indexation benefit.

Equity-Linked Saving Scheme (ELSS) is another equity scheme that deserves to be mentioned here. It is the most efficient tax saving scheme under Section 80C. ELSS has a lock-in period of 3 years.

Equity-oriented balanced and hybrid funds, in which at least 65% of the assets are invested in equities are also taxed the same way as equity mutual funds.

Taxation of Debt Mutual Funds

Taxation of debt mutual funds is very different from that of equity mutual funds.

As previously mentioned, If debt investments are sold under three years, they are considered short-term capital gains. These gains are then added to the income of the investor and taxed as per the income tax slab applicable to the investor.

The debt investments sold after three years will be considered long-term capital gains and taxed at 20% with indexation benefit.

The indexation benefit is what makes investing in debt mutual funds particularly attractive for investors looking for tax-efficient investment options.

In short, indexation helps in reducing tax as it inflates the purchase cost. Indexation achieves this by adjusting capital gains to cost inflation index (CII). it is important to note that indexation is applicable only on long-term capital gains earned on non-equity oriented mutual funds.

Indexation can be slightly difficult to follow, please read the detailed explanation provided here in order to understand how indexation actually works.

In addition to all of these, you also need to be aware of the Securities Transaction Tax (STT). The fund manager will charge you an STT of 0.001% if you decide to sell your units of the equity fund. STT is not applicable to the sale of units in debt mutual funds.

How to Declare Mutual Fund Investments in ITR

how to declare mutual fund investment in itr

Declaring your investment returns while filing your income tax returns is not as straightforward as it may seem. Let’s take a look at how you can do this in a seamless fashion.

If you are a salaried person with no accumulation of capital gains yet, you will need to fill in Form 1 along with Form 16 provided by your employer.

If, on the other hand, you are a salaried individual who has accumulated capital gains over the years, you will need to fill in Form 2.

ITR Form 2 is for individuals not conducting any other business under proprietorship but receive additional income from other sources apart from salary.

Additional Important Points to Keep in Mind

Before we proceed to conclude, we wanted to include a few important points to keep in mind when it comes to taxes paid for your mutual fund investments.

  1. If you decided to invest in mutual funds via a systematic investment plan (SIP), it is important to keep in mind that each SIP is considered as an individual investment. If you decided to redeem your investment after 12 months of SIP payments, all of your gains will not be free of tax. In this case, only the gains earned on the first SIP will tax-free as only that investment would have completed one year. The rest of the gains will be subject to short-term capital gains tax.
  2. It is also important to remember that tax is collected on the entire value of redeemed funds and not individual funds. If, for instance, the gains from your entire portfolio exceed Rs. 1 lakh, only then will your income be subject to LTCG of 10%.
  3. It might help if you can avoid frequent purchase and redemption of mutual fund units. Each redemption will be treated as a withdrawal and will be taxed as per the holding period. This is just an unnecessary expense that can be easily avoided.
  4. Your entire investment strategy should revolve around your financial goals. Any of the investments that do not align with your goals should ideally be redeemed promptly and moved into funds that can serve your financial goals better

Concluding Remarks

We hope you found this information useful. Understanding how taxation of mutual funds works can be intimidating in the beginning but as you continue to learn and invest, you will begin to a better picture.

Just make sure that you thoroughly understand a product before you begin your investment. This will ensure that you avoid expenses that come in the form of exit loads and other tax liabilities.

If you have any further questions, please feel free to browse through our blog. We try our best to provide as much information as possible by discussing many relevant topics that can help you make the right investment decisions.

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