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What is Tax on Mutual Funds?

Tax on mutual funds vastly depends on factors such as what kind of funds you have invested in (equity, debt or hybrid), the duration of your investment (long term or short term), mutual fund income (capital gains and dividend income) 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 especially for beginners. In this article we have covered how you earn returns on mutual funds and their taxation as per Income Tax Act, 1961.

Type of Mutual Fund Income

By investing in mutual funds an investor can earn returns in 2 forms- dividend and capital gains. The companies distribute dividends to its investors when they earn a surplus. An investor receives a dividend in proportion to the number of units they hold at the time of announcement of dividend. 
A capital gain arises when an investor sells any number of units of mutual funds. For the purpose of taxation, mutual funds are treated as capital assets and any sale may result in a capital gain or a loss. The dividend income as well as capital gains are taxable in the hands of the investors.
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.

Tax on Dividend Received From Mutual Funds

From April 1st, 2020, mutual funds dividends are taxable in the hands of investors. The dividend income is taxable under the head ‘Income From Other Sources’ at the applicable income tax slab rate for the financial year.

In addition to such a taxation, the distributor of dividend income must deduct TDS (tax deducted at source) at a rate of 10%. However, TDS will not be deducted if the total dividend paid by such distributor during the financial year is less than Rs 5,000. If you fail to provide the PAN to such a distributor will deduct TDS at a rate of 20%.

For a lower or nil deduction of TDS you can submit Form 15G or Form 15H. A resident individual can submit Form 15G if the total taxable for the financial year is less than the basic exemption limit. A senior citizen can file Form 15H if the total tax payable for the financial year is nil. The company or mutual fund will intimate its investors regarding the distribution of dividend through an email. You can submit the Form 15G or Form 15H, as the case may be, before the due date of submission as directed in the email.

Explore: What is Dividend Reinvestment Plan?

Tax on Capital Gain Received From Mutual Funds

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). 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.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.

The capital gains depend on the period of holding and the type of capital asset. 

  • Period of Holding: 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 a short-term investment. Any investment over one year is long-term investment.
    • Until March 31st 2023, In the case of debt mutual funds, an investment tenure of up to 3 years (36 months) is short-term investment. Any investment over a period of 3 years is considered long-term. From April 1st 2023, capital gains from debt mutual funds are considered as short term gains.
  • Taxation by Fund Type: 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.

Learn: how to invest in mutual funds.

Taxation of Mutual Funds Depends on Capital Gain Holding Period

Type of Mutual FundShort Term Capital Gain Holding PeriodLong Term Capital Gain Holding Period
Equity FundsLess Than 12 MonthsMore Than 12 Months
Debt Funds (Until 31st March 2023)Less Than 36 MonthsMore Than 36 Months
Hybrid Fund- Equity OrientedLess Than 12 MonthsMore Than 12 Months
Hybrid Fund- Debt Oriented (Until 31st March 2023)Less Than 36 MonthsMore Than 36 Months

Capital Gain Tax on Equity Funds

If equity investments are sold within 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 is the most efficient tax saving scheme under Section 80C. ELSS mutual funds and 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. 

Capital Gain Tax on Debt Funds

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

As previously mentioned, until March 31st 2023, 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.

If the holding period of the debt investments is more than three years, the gains are 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. 

From April 1st 2023, debt mutual funds no longer have the benefit of long term capital gains. The capital gains arising from debt funds will be taxable as per the investor’s Income Tax Slab rate.

Capital Gain Tax on Hybrid Funds

Capital gain on Hybrid Mutual Funds is simply as per the asset allocation of such a fund. If the hybrid fund is equity oriented then the tax treatment is the same as of equity mutual funds. Similarly, hybrid funds are debt oriented then the tax treatment is the same as debt mutual funds. If the fund invests more than 65% of its corpus in equity and equity related securities then it is an equity oriented fund. Otherwise, it is a debt oriented fund. Accordingly, the taxability will depend on the percentage of investment in equity or debt securities.

Tax on Mutual Fund Redemption 2024

Type of Fund
Short-Term Capital Gains STCG

Long-Term Capital Gains LTCG

Equity funds

15% + cess + surcharge

Up to Rs 1 lakh a year is tax-exempt.
Any gains above Rs 1 lakh are taxed at 10% + cess + surcharge

Debt funds

Taxed at the investor’s income tax slab rate
From April 1st 2023, all capital gains will be taxed at the investor’s income tax slab rate.

Until March 31st 2023: 20% + cess + surcharge
From April 1st 2023: No LTCG Benefit

Hybrid equity-oriented funds

15% + cess + surcharge

Up to Rs 1 lakh a year is tax-exempt.
Any gains above Rs 1 lakh are taxed at 10% + cess + surcharge

Hybrid debt-oriented funds

Taxed at the investor’s income tax slab rate
From April 1st 2023, all capital gains will be taxed at the investor’s income tax slab rate.

Until March 31st 2023: 20% + cess + surcharge
From April 1st 2023: No LTCG Benefit

Tax on SIP Investments

If you decide 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.

Tax on SWP Investments

With SWP Systematic Withdrawal Plan an investor can systematically withdraw or redeem an amount every month at a predetermined date. Hence, an investor withdraws a number of units equivalent to the amount withdrawn every month. Such a withdrawal attracts capital gain. Just like capital gain on SIP, under SWP as well the computation of the period of holding is per withdrawal. And the rate of tax depends on the type of mutual fund scheme.

For instance, you have invested on 1st December 2022 Rs 5 lakh for a NAV of Rs 50 for 10000 units of a debt fund with an instruction to withdraw Rs 10,000 every month. When you withdraw Rs 10,000 the equivalent number of units are withdrawn. For the month of 1st January 2023 you have withdrawn Rs 10000 at an NAV of Rs 75 per unit. Hence the holding period will be 1 month from 1st December 2022 to 1st January 2023. 

What taxes do NRI have to pay?

Tax Rate:

  • Tax on Short Term Capital Gains (STCG) from Debt (non-equity) mutual funds : Based on your income tax slab
  • Tax on Long Term Capital Gains (LTCG) from Debt (non-equity) mutual funds:  20% with indexation benefit
  • Tax on Short Term Capital Gains (STCG) from equity mutual funds : 15%
  • Tax on Long Term Capital Gains (LTCG) from equity mutual funds:  10% on gains above ₹1 lakh in a financial year

TDS:

Unlike resident Indians, any withdrawals from mutual funds by NRIs are subject to deduction of TDS. The money you receive in your bank account from withdrawal is net of the TDS amount. TDS is charged at the highest income tax slab rate. When your file your tax returns in India, you are eligible to get the excess TDS amount as refund. Following TDS rates apply:

  • TDS on Short Term Capital Gains from debt (non-equity) mutual funds : 30%
  • TDS on Long Term Capital Gains from debt (non-equity) mutual funds:  20% with indexation benefit
  • TDS on Short Term Capital Gains from equity mutual funds : 15%
  • TDS on Long Term Capital Gains from equity mutual funds:  10%

Points To Keep in Mind for Tax on Mutual Funds

  1. Every withdrawal of units of mutual funds attracts capital gains irrespective of SIP, SWP, or SPT.
  2. Capital gains are taxable in the financial year in which you redeem your units.
  3. Make sure you select the correct income tax return applicable to you. 
  4. If you are a salaried taxpayer with capital gains then ITR-2 is applicable. To know more on which ITR to file you can read our article.
  5. You can set off the loss from capital assets with capital gains. You can set off short term capital loss with LTCG and STCG. However, you cannot set off long term capital loss with STCG. Furthermore, you can set off long term capital loss with LTCG only.
  6. The period of holding is a major factor. It is advisable to hold the investments for a longer period. The longer you hold your investments the more tax you will save. This is because tax on long term capital assets is lower than short term capital assets.  

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Frequently Asked Questions

What is Securities Transaction Tax (STT)?

In addition to capital gains tax and dividend tax, mutual fund transactions also attract securities transaction tax (STT). The Ministry of Finance levies 0.001% tax when you buy or sell mutual fund units of equity or equity oriented hybrid fund. Selling debt mutual fund units doesn’t attract any STT.

Are mutual fund taxes payable every year?

No. You are liable to pay taxes on mutual fund returns/ gains only when you sell your holdings. However, the dividend income is added to your total taxable income. Thus, you will have to pay tax on the dividend income every year as per your income tax slab.

Is it possible to avoid capital gains tax?

No, you cannot avoid capital gains tax. However, you can plan your investment in a more tax-efficient manner. For instance, short-term capital gains for mutual funds are higher than long-term capital gains. Thus, you can invest for the long term to reduce your total tax liability.

Are all mutual funds tax savings investments?

No. All mutual funds do not qualify for tax savings. Only investments in Equity Linked Savings Schemes (ELSS) qualify for tax exemption under Section 80C of the Income Tax Act, 1961. Investments up to INR 1,50,000 per annum qualify for this exemption. Moreover, ELSS funds come with a mandatory lock-in period of three years.

How to declare mutual fund investments in ITR?

When you sell your mutual fund holdings, you must disclose the details while filing the Income Tax Returns. You must generate the capital gains statement. This statement comprises both short-term and long-term capital gains. Next, while filing your returns, you must declare these capital gains and input all the information pertaining to the date of purchase, purchase amount, and sale details, transfer expenses, etc. If you are a salaried individual applicable ITR form will be ITR-2, and for income from business and profession, it is ITR-3.

Can mutual fund investments help me get a rebate on income tax?

Only investments in tax-saving mutual funds qualify for tax deduction under Section 80C of the Income Tax Act, 1961. Investments up to INR 1,50,000 qualify for this exemption. Thus, you can save INR 46,800 every year on taxes.

What are tax savings mutual funds?

Tax-saving mutual funds are funds whose investment qualifies for tax exemption under Section 80C of the Income Tax Act, 1961. These funds are called Equity Linked Savings Schemes (ELSS). The exemption limit per annum is INR 1,50,000. Furthermore, tax-saving mutual funds come with a mandatory lock-in period of 3 years.