A Guide to Taxation in Mutual Funds!
In the early article, we discussed financial planning. In this article, we will try to under the taxation in the mutual fund system that applies to mutual fund investments.
Factors determining the taxation of Mutual funds
To know the taxation structure, first, you need to identify which type of mutual funds you have invested in and whether the fund you hold is an equity mutual fund or a debt-oriented mutual fund.
Along with this, the type of income that you are generating from the fund, whether a capital gain or dividend income – both these types of income are taxable in different ways.
Finally, your holding period is crucial in knowing the taxes applicable to your mutual funds’ portfolio.
Earnings in mutual funds
There are usually two ways in which money is earned in mutual funds: one through the selling of the mutual fund (capital gain) and the other through dividend income.
For example, if you are holding units of a mutual that you purchased at a NAV (Net Asset Value) of Rs. 100, and you sell it when its NAV of Rs. 150, you make a capital gain of Rs. 50; it is worth noting that capital gains tax accrues on the mutual funds’ units only after redemption.
The tax will be payable when you file your income tax returns for the coming fiscal year.
The second way to earn from mutual funds is dividend income – the fund declares dividends for the holders based on the surplus that it has for distribution Dividends are taxable as soon as the dividend amount hits the bank accounts of the investors.
Tax on capital gains
Here, there are again two parts to the story – whether the realized capital gains have come from equity mutual funds or debt mutual funds.
An equity mutual fund has an equity exposure of greater than 65%. For equity mutual funds, if the gains have been realized within 12 months of holding, then the applicable tax rate is flat at 15% on the gains (irrespective of your income tax bracket).
When the holding period exceeds 12 months, the capital gains of Rs. 1,00,000 are exempt from taxes. Any amount upwards of Rs. 1,00,000 is taxable at 10%, along with the provision of indexation benefits.
For debt mutual funds (funds with greater than 65% exposure to debt instruments) – the holding period is considered short-term if it is less than 36 months; anything more than that is long-term.
For the short term, the tax rate is in accordance with your income tax slab. On the other hand, for debt funds held for more than 36 months, the gains are taxable at a flat rate of 20% post-indexation (plus, some cess and surcharge are added).
A possible third case is hybrid funds (funds with a mix of debt and equity) it is simple, their tax treatment is supposed to be on the basis of the fund’s exposure to debt and equity.
If the hybrid fund is equity-focused: LTCG is charged at 10% on capital gains exceeding Rs. 1 lakh (without indexation), and STCG is charged at 10%.
If the hybrid fund is debt-focused: LTCG is charged at 20% with indexation benefits, and STCG is charged per income tax slab.
Tax on dividends
Now, when it comes to taxation of dividends paid out on mutual funds, it is done by adding the dividend to the investor’s taxable income, and then the individual income tax slab rate is applicable; this is in accordance with the amendments made by the union budget of 2020.
Earlier, dividends were tax-free in the hands of investors since the companies paid the Dividend distribution tax (DDT) before sharing the profits with the investors.
Dividends (received from domestic companies) of up to Rs. 10,00,000 per year were tax-free in the hands of the investors during this period. Dividends above Rs. 10 lakhs were subject to a dividend distribution tax of 10%.
Aside from the dividends and capital gains taxes, there is also a securities transaction tax (STT).
When you acquire or sell mutual fund units of an equity or a hybrid mutual fund, the government charges an STT of 0.001%. It is important to note that selling units of debt funds are exempt from the STT.
Important points to note
There are tax-saving equity funds as well. Investments made under the ELSS (Equity-linked savings schemes) qualify for tax exemption under section 80C of the Income-tax Act (exemption up to Rs. 1,50,000).
Please note that ELSS schemes come with a lock-in period of 3 years – that is, investors cannot redeem the units before three years. LTCG (long-term capital gains tax) is not applicable for gains up to Rs. 1,00,000.
For LTCG more than Rs 1 lakhs, the applicable tax rate is 10% without indexation.
Taxation in the case of SIP (Systematic Investment plans)
Let us understand this with the help of an example
An investor invests Rs. 10,000 every month from April 2021, and another investor invests Rs. 60,000 lump sum at the same time.
When both of them redeem their funds simultaneously, Rs. 10,000 will qualify for tax exemption for the SIP investor because the investment made in 2021 would exceed one year as of May 2021. In contrast, the entire capital gain isn’t taxable for the lump sum.
Investing in the long term can be more tax-efficient than holding the units for a short duration.
How much amount is taxed in mutual funds?
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. 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%
Is SIP in mutual funds taxable?
Yes, SIP in the mutual fund is taxable. The tax amount differs based on the duration and returns generated
Which mutual funds are tax-free?
Profits from the sale of ELSS fund units are considered long-term capital gains and have tax exemption.
Consult an expert advisor to get the right plan for you