Taxation on Mutual Funds

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Mutual Funds can provide earnings in two forms- Capital Gains and Dividends. While capital gains are taxable at the hands of investors, the tax on mutual funds dividends, called Dividend Distribution Tax (DDT) is paid by the fund house (Asset Management Company) on behalf of the investors.

Mutual funds can be an ideal investment option for wealth creation. Whether it is about capital gains or earning a regular income, investors can choose from a wide variety of funds available in the market. Also, the capital gains from your investment are taxable as per the holding period and prevailing income tax laws. Let us have an in-depth look at the various aspects of the taxation of mutual fund investments.

What are capital gains and how are these classified as per the holding period?

Capital gains relate to the difference between the price at which you buy the units of a mutual fund and the price at which you sell them. Take the example of an individual who invests Rs 2 Lakh in an equity fund on 1 January 2016. Assume that after 2 years, when they redeem the units, the value of the portfolio stands at Rs 2.5 lakh. Thus, they earn Rs 50000 by way of capital gains. From a holding period perspective, capital gains can be classified as Short-term Capital Gain (STCG) and Long-term Capital Gain (LTCG).

When you redeem the units of an equity fund within one year from the date of purchase, you tend to make capital gains known as STCG. On the other hand, if you redeem your investment after one year, then the underlying profit would be termed as LTCG.

How is Mutual Funds Taxed on Capital Gains?

The short-term capital gains are known as short-term capital gains (STCG). Long-term capital gains (LTCG) are regarded as long-term capital gains.

Depending on their holding periods, equity and debt funds are taxed differently. Short-term capital gains (STCG) on equity fund unit redemption are taxable at a rate of 15%. Long-term capital gains (LTCG) are tax-free on equity funds up to Rs 1 lakh. However, LTCG on the redemption of the equity fund exceeding Rs 1 lakh is taxable at a rate of 10% without indexation advantage.

The short-term capital gains on debt fund units are part of the investor’s full revenue and are taxable on the basis of his income slab. However, with the advantage of indexation, long-term capital gains on debt fund redemption are taxable at a rate of 20 percent. In the case of indexing, the cost of acquiring the units can be adjusted based on the cost inflation index (CII) of the year of sale and year of purchase.

Indexed cost of acquisition (ICoA) is computed as follows:

ICoA = (Purchase Price * CII of year of sale) / (CII of the year of purchase)

Indexation’s primary aim is to inflate the procurement price of the asset in order to decrease the resulting capital gains. The investor can thus reduce his overall tax liability.

How Mutual Fund Dividend is taxed?

There is no tax liability on investors when it comes to the dividend received from equity mutual funds. However, dividends reach in the hands of investors after a deduction of Dividend Distribution Tax (DDT) at 11.648% (including surcharge and cess), thereby reducing the overall in-hand return.

Debt mutual funds dividends are tax-free in the investor’s hands, but debt mutual funds dividend payouts are subject to a dividend distribution tax of 29.12 percent (including cessation and surcharge). This efficiently lowers investors ‘ in-hand returns.

Ways to Manage Mutual Fund Taxation

Taxing on mutual fund capital gains should not prevent you from exploring its potential for return. In fact, through mutual fund investments, you can generate a lot of wealth and achieve your goals.

  • Make sure you fully comprehend the product before investing in any mutual fund scheme.
  • Throughout the investment horizon, you can remain invested in the product without making unplanned exits that attract tax liability.
  • Analyzing the funds for qualitative and quantitative reasons helps prevent selecting inappropriate funds. Consult a professional financial advisor in case of any difficulties.
  • Refrain from frequent buying and redeeming units from the mutual fund.
  • Consider the tax implications if you plan to initiate a systematic transition from debt to equity fund or vice versa.
  • Redemptions shall be regarded as withdrawal and shall be taxable according to the holding period.
  • While investing in equity funds, in order to realize the complete potential, have a long-term horizon of more than 5 years.

Tax Benefit of Mutual Funds

Amongst the various mutual fund categories, ELSS funds offer you tax advantage along with the opportunity to create wealth. Investing in these funds makes you eligible to avail a deduction of up to Rs 1.5 lakh every year under Section 80C of the Income Tax Act. These funds have a lock-in period of three years after which you would be able to redeem your investments.