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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, and which income tax slab you belong to.

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 mutual fund taxation.

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

Tax on Mutual Funds
tax on mutual funds

Types of Mutual Funds in India

You may have heard of words like Debt funds, Equity funds, ELSS funds, Index funds, Liquid funds, Income funds being used often. However, mutual funds are broadly categorized as Equity funds, Debt funds, and Hybrid funds.

In this article, we want to discuss mutual fund taxation and help you understand how your mutual fund returns are taxed.

investing in mutual funds is one of the best ways to make sure that you have enough money for all your financial requirements for years to come. Hence, to have a clear picture of the returns on your mutual funds, you need to know how much you will be paying in taxes.

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 Gain Tax on Mutual Funds

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 mutual funds capital gains mean.

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 taxable income.

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

Capital gains tax in India 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 mutual fund dividend payout impacts your taxes.

Tax on Dividend Income

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.

In the Union Budget 2020, the finance ministry has changed the mutual fund’s dividend tax rules in India. Dividends will now be taxable in the hands of investors and DDT os scrapped. Hence, fund houses need not pay the Dividend Distribution Tax DDT on equity mutual funds and debt mutual funds starting April 1st, 2020.

Before scrapping the Dividend Distribution Tax (DDT), this is how dividends on equity mutual funds and debt mutual funds were taxed in India.

FundDDT Base RateSurchargeCessEffective DDT
Equity Mutual Funds10%1.2%0.448%11.648%
Debt Mutual Funds25%3%1.120%29.120%

A surcharge of 12% on base rate and cess of 4% on base + surcharge rate is included in DDT.

From April 1st, 2020, mutual funds dividends are taxed in the hands of investors at their income tax slab rate. This is done to reduce the burden on small investors. Dividend income will be treated as normal income and added to the total income and is taxable at the income tax slab rate.

Additionally, mutual funds dividends paid out to a person is more than INR 5,000 is subject to TDS (tax deducted at source) of 10%. If the PAN is linked to Aadhar, this rate is applicable. In its absence, the TDS will be 20%.

The new mutual fund’s dividend tax rules have made dividend plans less attractive. This change will now boost the sales of growth and SWP plans.

Difference between Growth Option and Dividend Option in Mutual Funds

There is one significant 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 the extent of dividends paid. It 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 the long-term, and for wealth generation, 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 in India

Two essential factors 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.

Type of Mutual Fund Scheme

Income tax on mutual funds in India depends on the type of mutual fund. 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 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. Within equity funds, the popular ones are large caps, mid-caps, and small-cap mutual funds. You can also learn more about equity mutual funds here.

On the other hand, debt mutual funds invest in relatively safer investment options such as government bonds, corporate bonds, etc.that offer a fixed return. Liquid funds, short-duration funds, and income funds are just a few types of debt funds. You can also 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 income tax on mutual funds is 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 one 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.

Tax on Equity Mutual Funds

If equity investments are sold under one year, the fund returns are treated as short term capital gains (STCG). These are subject to short term capital gain tax of 15% (plus 4% cess). 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 gains over Rs. 1 lakh is subject to LTCG tax of 10% (plus 4% cess) without any indexation benefit. 

Equity-Linked Saving Scheme (ELSS funds) is another equity scheme that deserves to be mentioned here. It is the most efficient tax saving scheme under Section 80C. ELSS mutual funds have 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. 

Tax on Debt Mutual Funds

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

As previously mentioned, If debt investment is sold under three years, they are considered as short term capital gain. This short term capital gain is then added to the investor’s income 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. These are subject to the LTCG tax of 20% with indexation benefit. 

The indexation benefit 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 the cost inflation index (CII). It is important to note that indexation applies only to long-term capital gains earned on non-equity oriented mutual funds. 

Indexation can be slightly tricky to follow. Please read the detailed explanation provided here to understand how indexation 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 equity fund units. Securities Transaction Tax STT does not apply to the sale of units in debt mutual funds. 

How to Declare Mutual Fund Investments in ITR

Declaring your investment returns while filing your income tax returns is not as straightforward as it may seem. Let’s look at how tax filing of capital gains can be done seamlessly.

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.

While filing your income tax returns, mutual fund investments have to be declared. However, investments in tax savings funds like ELSS mutual funds help save tax under section 80c.

Also, Scripbox Income tax calculator can be used to determine the taxable income and makes the tax filing process easy for an investor. It also suggests investment plans in case there is scope to save tax. 

Additional Important Points to Keep in Mind

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

If you decided to invest in mutual funds via a systematic investment plan (SIP), it is essential to keep in mind that each SIP is considered as an individual investment. And, if you decided to redeem your investment after 12 months of SIP payments, all of your gains would not be free of tax. Only the gains earned on the first SIP will be 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. Also, you can calculate your SIP returns using the Scripbox SIP Calculator.

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%.

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.

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. However, as you continue to learn and invest, you will get 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. Also, you can always use online mutual fund calculators like SIP calculator and lump sum returns calculator to determine the potential returns from mutual fund investments. And use an income tax calculator to find out what might be your tax liability while filing income tax returns. 

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.

Published on February 12, 2020