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Demystifying Taxation In Mutual Funds

Tax forms an important component to factor in when you are screening mutual funds to invest. These financial vehicles are considered to be more tax friendly compared to fixed deposits with banks.

Mutual funds also provide investors with higher returns than bank deposits and hence have become the go-to investment product for a large number of investors globally.

To understand the taxation in mutual funds, we first need to understand the income streams in this vehicle. Sources of inflow to investors in mutual funds is through capital gains and through dividends.

Dividends: The tax on the dividend is paid by the Asset management company or the fund house in the form of Dividend Distribution Tax (DDT) before it reaches the hands of the investor.

Capital Gains: The difference in value of the units of the mutual fund at purchase and at sale/redemption. This is taxable based on the type of mutual fund and the duration or holding period.

Type of Funds are as follows

Holding period: The classification of holding period is defined as follows based on the type of the mutual fund.

Fund Type Short-term Capital Gains Long-term Capital Gains
Equity  Up to 12 months >12 months
Debt Funds Up to 36 months >36 months
Balanced funds Up to 12 months >12 months

Equity Funds

The taxation in taxable Equity funds and balanced funds(with equity exposure of >65%) could be explained using the following examples:

Consider that you had purchased units of ABC Equity fund for Rs 1 lakh in the year 2020-21 (post-April 2020). If the NAV of the fund had increased over the period of time, the value of your investments would also increase. 

Invested amount 100000
Final Value of amount 150000
Capital Gains 50000
Tax Rate 15%
Tax Payable 7500

Equity STCG: If the investor claims redemption in less than 1 year of investment, it would fall under the Short-term Capital Gains (STCG) category. The tax rate would be 15% on the gains earned by the investor.

Invested amount 100000 200000
Final Value of amount 150000 400000
Capital Gains 50000 200000
Tax Rate 10%
Tax Payable 0 10000

Equity LTCG: If the investor holds the investment for more than a year, (say April 2020 – May 2021), the gains would be taxed at long term capital gains (LTCG) tax of 10%. There is however an additional clause in LTCG, which states that the gains less than Rs 1 lakh are exempted from tax.

As shown in the table, an investor whose capital gains were Rs 50,000 need not pay any tax. Similarly, an investor who has earned 2 lakhs for his investment would pay tax on the additional 1 lakh only = 10%* 1,00,000 = Rs 10,000.

Tax Saving Equity Funds

Equity Linked Saving Scheme (ELSS) investments are deductible under Section 80C of Income Tax Act 1961. Here, the investor can claim a tax deduction for an amount <Rs 1.5 lakhs.

If the investor has no other deduction such as PF, Insurance etc, and if the investor’s tax bracket is 20%, he would be eligible for Rs 30,000 as tax savings. However, ELSS comes in with a lock-in period of 3 years, where the investor cannot withdraw or claim for redemption.

After 3 years, on redemption, the capital gains are taxed at 10% (exempted for Rs 1 lakh), similar to the above example of Equity LTCG.

Debt Funds: The taxation of Debt funds and hybrid or balanced funds (with an equity exposure of <65%) can be explained with the examples as follows:

  STCG for Debt Fund LTCG for Debt Fund
Debt Funds Up to 36 months >36 months
Tax Rate Income Tax slab rate 20% with Indexation

STCG: If the investor holds the investment for less than 3 years (say April 2020 – Feb 2023), and considering the Income-tax slab of the investor to be 20%. For the above example of capital gains of Rs 50,000, the investor would be paying 20%*50,000 = Rs 10,000 as tax.

LTCG: This comes with the benefit of Indexation, where the price of the purchase or initial investment is adjusted for inflation using the Cost Inflation Index (CII).

For example, an investment of Rs 100 was made in the year 2016-17 and wants to sell the investments or redeem them in the year 2019-2020. Consider that the value of the investment has increased to Rs 170, hence providing a capital gain of Rs 70 to the investor.

CII 2016-17 264
CII 2019-20 289
Cost of Purchase or Investment Amount 100
New Cost is Adjusted for inflation                            109.47 

However, this price is adjusted for inflation as follows –

New Cost of Purchase = CII of Year of Investment (here, 2016-17) CII of the year of redemption (here, 2019-20) X Amount invested.

Hence, as the cost increases, the Capital gains reduces, tax payable also reduces.

In the above example, Capital Gains = 170 -109.46 = 60.53. Tax payable = 20%*60.53 = Rs 12.11 (instead of 20%*70 = 14).

NOTE: The indexation is applicable only for Non-equity-oriented schemes with a long-term holding period.

Taxation SIP Vs Lumpsum

SIPs allow the investors to invest small amounts periodically into the fund. During redemption, these units are claimed on a first-in-first-out basis. 

Consider a SIP investment of 1 year where you invested Rs 500 per month. Consider that you purchased 10 units in the first month. If the SIP is redeemed after 13 months, the first month is considered as long-term holding and capital gains of the month are taxed at 10% (considering the capital gain exemption of Rs 1 lakh). The remaining SIP amounts from the second month are categorised as short-term and capital gains are taxed at 15%.

Comparison of SIP vs Lumpsum

SIP vs Lumpsum 13 months
Lumpsum (entire amount’s capital gains considered for LTCG) SIP (first month capital gains are considered for LTCG)
Monthly amount                                   –    5000
Invested amount 60000 60000
Tax exempted amount for LTCG 60000 5000

In a Nutshell

Fund Type Parameters Short-term Capital Gains Long-term Capital Gains
Equity and Balanced funds (>65% in Equity) Holding Period Up to 12 months >12 months
Tax Rate 15% 10% (For amount > Rs 1 lakh)
Debt Funds and Balanced funds (<65% in Equity) Holding Period Up to 36 months >36 months
Tax Rate Income Tax slab rate 20% after Indexation

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