Tax on Mutual Funds: How are Mutual Funds Taxed?
Mutual funds are highly regarded for their potential profitability, simplifying the achievement of financial goals. They offer tax efficiency, which is a key advantage. However, investing in mutual funds without considering the tax on mutual funds can lead to suboptimal outcomes.
Investors must consider factors beyond taxation, such as taxes on dividends and redemptions, as these can significantly affect cash flow. Understanding taxation on mutual funds also aids in strategically planning investments to minimise overall tax liabilities. This blog explores the different aspects of mutual fund taxation, providing essential insights about tax on mutual fund redemption for investors.
What is Taxes on Mutual Funds?
When investing in mutual funds, investors must consider the taxation on mutual funds. Any profit investors may make when selling mutual fund units is known as capital gains. Based on how long investors hold the units, these gains are classified into short-term and long-term.
Short-term gains apply if investors hold the units for less than three years. They are taxed according to your Income Tax Rate. On the other hand, gains from units held for more than three years are categorised as Long-Term Capital Gains (LTCG) and are taxed accordingly.
Factors Affecting Mutual Fund Taxation
If you’re wondering how mutual funds are taxed, you should first know that mutual fund taxation hinges on a few key factors:
- Fund Types: Mutual Funds are categorised into equity-oriented and debt-oriented funds for tax purposes.
- Capital Gains: This refers to profits made when selling a capital asset for more than its purchasing cost.
- Distribution: Formerly known as dividends, distributions are now termed ‘Income Distribution cum Capital Withdrawal Plan’ or IDCW Plan after SEBI changed its nomenclature on 1st April 2024. These are portions of accumulated profits distributed to investors without requiring them to sell their assets.
- Holding Period: The period of holding for investments can impact the tax you pay on capital gains. Longer holding periods generally result in lower tax liabilities, aligning with India’s tax policies and encouraging sustained investments.
How are Mutual Fund Returns Earned?
The mutual funds tax landscape is divided into two categories. Let’s define these terms and explore their differences.
- Capital Gains: Capital gains refer to the profit from selling an asset for more than its purchase price. This gain is realised in mutual funds only when the fund units are redeemed. Consequently, the capital gains tax on mutual fund redemption is payable when redemption becomes due for the upcoming fiscal year’s income tax returns.
- Dividends: Another way investors earn from mutual funds is through dividends. These are payments made to investors from the fund’s distributable surplus. When investors receive dividends from their mutual funds, these are immediately subject to taxation . Thus, investors must pay tax on the dividends received.
Note: On 1st April 2021, the Securities and Exchange Board of India (SEBI) renamed mutual fund dividends. Dividends are now referred to as ‘distributions’. The dividend plan of mutual fund schemes is now called the ‘Income Distribution cum Capital Withdrawal Plan’ (IDCW Plan).
Taxation on Dividends Offered by Mutual Funds
The Finance Act of 2020 brought about an amendment that eliminated the Dividend Distribution Tax (DDT). Previously, until 31st March 2020, dividend income from mutual funds was tax-free for investors. Fund houses that declared dividends deducted a Dividend Distribution Tax (DDT) before distributing it to mutual fund investors. Additionally, on 1st April 2021, SEBI has renamed mutual fund dividends. Dividends are now referred to as ‘distributions’. The dividend plan of mutual fund schemes is now called the ‘Income Distribution cum Capital Withdrawal Plan’ (IDCW Plan).
The Union Budget 2024 has introduced changes to the taxation framework for dividends received from mutual funds, which are important for investors to understand. Under the revised mutual fund dividend tax rules, here are the changes:
- Tax Deducted at Source (TDS): The budget has removed the 20% TDS on the repurchase of mutual fund units. This means that investors will no longer have TDS deducted at the time of redemption, allowing them to receive the full amount. However, investors are still responsible for calculating and paying the appropriate capital gains tax when filing their income tax returns.
- Dividend Income: Dividends received from mutual funds are now taxed according to the investor’s income tax slab rate. This change aligns with the previous budget, which shifted the tax burden on dividends from the mutual fund companies to the individual investors.
These changes mean that while investors will receive their dividend income without the deduction of TDS, they must ensure to report this income correctly in their tax filings and pay taxes according to their applicable slab rates. This can simplify cash flow but requires careful tax planning and compliance.
Taxation on Capital Gains Provided by Mutual Funds
It’s essential to understand how the mutual fund income tax rules apply to your gains.The mutual fund capital gains tax depends on the type of schemes you’ve invested in and the duration of your holding of scheme units.
Firstly, let’s clarify the meanings of long-term capital gain taxation of mutual funds (LTCG) and short-term capital gain (STCG) tax on mutual fund returns . Tax on LTCG pertains to the capital gain tax on mutual funds redemption arising from assets held for an extended period, typically over one year. Conversely, short-term capital gain on mutual funds or STCG tax on equity funds refers to the capital gain from assets held for a relatively shorter duration, typically less than a year.
Regarding tax treatment, the definitions of “long” and “short” durations differ for tax on equity and debt fund schemes. For instance, to qualify for long-term capital gains on mutual funds, you must hold your investment for at least 12 months in equity-oriented schemes, while it’s 36 months for debt-oriented schemes. Understanding the tax on mutual funds withdrawal is crucial for effective tax planning and maximising your investment returns.
Now that you know how mutual funds are taxed, the table below provides an overview of the required period of holding for capital gains to be considered long-term or short-term:
| Types of Mutual Funds | STCG Holding Period | LTCG Holding Period |
| Equity Funds | Less Than 12 Months | More Than 12 Months |
| Debt Funds | Less than 36 Months | More than 36 Months |
| Hybrid equity-oriented funds | Less Than 12 Months | More Than 12 Months or Longer |
| Hybrid debt-oriented funds | Always Short-Term | Always Short-Term |
Taxation on Equity Mutual Funds Capital Gains
Equity funds are mutual funds in which over 65% of the total fund value is invested in equity shares of companies. As explained earlier, if you redeem your mutual fund equity units within one year, you incur short-term capital gains, taxed at a flat rate of 20%, regardless of your income tax mutual funds bracket.
On the other hand, selling mutual fund units after holding them for more than one year, you will realise long-term capital gains. Up to Rs 1.25 lakh annually, these gains are exempt from tax. However, long-term capital gains exceeding this limit are subject to a 12.5% LTCG tax without the equity mutual fund tax benefit of indexation.
Taxation on Capital Gains Offered by Debt Funds
The 2024 Budget introduced changes affecting the taxation of Specified Mutual Funds. Debt mutual funds no longer benefit from indexation when calculating long-term capital gains (LTCG). Instead, these gains are taxed at the applicable income tax slab rates.
This change also applies to gold mutual funds, hybrid mutual funds, international equity mutual funds, and funds of funds (FOF). As a result, investors might prefer investing directly in debt securities to avoid mutual fund management fees. Higher taxes on profits may deter investors, reducing the appeal of these mutual funds.
- Short-Term Capital Gains (STCG): If you sell your debt fund units within three years (36 months), the tax will be as per your income tax slab.
- Long-Term Capital Gains (LTCG): For debt funds held for over three years (36 months), the tax rate is now a flat 12.5% without indexation benefits.
Taxation on Capital Gains Provided by Hybrid Funds
The tax rate on capital gains for hybrid or balanced funds depends on the portfolio’s equity exposure. If the equity exposure is over 65%, the fund is taxed like an equity fund. If it is 65% or less, debt fund tax rules apply.
Knowing the equity exposure of your hybrid scheme is crucial to avoid unexpected tax on mutual fund redemption. There is no indexation benefit on these taxes. If you’re wondering how to calculate tax on mutual fund redemption, the table below summarises the tax rates for hybrid mutual fund capital gains:
| Types of Fund | Short Term Capital Gains | Long-Term Capital Gains |
| Equity funds | 20% for less than 12 months | 12.5% for more than 12 months |
| Debt funds | If you sell your debt fund units within three years (36 months), the tax will be as per your income tax slab | For debt funds held for over three years (36 months), the tax rate is now a flat 12.5% without indexation benefits. |
| Hybrid equity-oriented funds | 20% for holdings less than 1 year | 12.5% for holdings over 1 year, with gains up to Rs. 1.25 lakh tax-free |
| Hybrid debt-oriented funds | Taxed as per income tax slab for holdings less than 3 years | 12.5% for holdings over 3 years |
Taxation on Capital Gain When Investing in SIPs
Systematic Investment Plans (SIPs) allow investors to periodically invest small amounts in mutual fund schemes, offering flexibility in choosing the investment frequency, such as weekly, monthly, quarterly, bi-annually, or annually.
With each SIP instalment, you acquire a specific number of mutual fund units, and upon income tax on mutual fund redemption, the units are liquidated on a first-in-first-out basis. The tax on SIP follows the same principles as the mutual funds taxation, as each SIP installment is treated as a fresh investment. For instance, if you invest in an equity fund through SIPs for one year and redeem your entire investment after 13 months, the units purchased initially through SIPs qualify as long-term holdings (over one year). Any long-term capital gains on these units under Rs 1 lakh are tax-free.
On the other hand, units purchased through SIPs from the second month onward are considered short-term holdings, resulting in short-term capital gains. These gains are taxed at a fixed rate of 15%, irrespective of your income tax bracket, with applicable cess and surcharge added to the tax amount.
If debt mutual fund units bought via SIPs are redeemed within three years, gains are taxed as short-term capital gains based on income tax slabs. If held for over three years, they’re taxed as long-term capital gains at a 20% flat rate with indexation benefits, which adjusts the investment’s cost for inflation, reducing taxable gains.
Taxation on Capital Gains When Investing in Tax Saving Mutual Funds or ELSS
Equity-Linked Savings Scheme (ELSS) is a mutual fund that invests at least 80% of its funds in stocks. ELSS offers an attractive option for those looking at the tax benefits of mutual funds. Investing in ELSS allows you to deduct up to Rs 1.5 lakh from your taxable income under section 80C of the Income Tax Act, 1961 which helps in tax saving.
However, the total deductions under section 80C have a maximum limit of Rs 1.5 lakh. If you claim deductions for other expenses under this section, the deductible amount for ELSS investments will be reduced accordingly.
ELSS has a three-year lock-in period, during which you cannot withdraw your investment. After this period, you can withdraw your funds, and any gains will be subject to long-term capital gains (LTCG) tax rather than short-term capital gains (STCG) tax. Additionally, you can take a loan against your ELSS investment.
According to the latest Budget 2024 announcement, the LTCG exemption limit has been raised from ₹1 lakh to ₹1.25 lakh, and the LTCG tax rate has been adjusted from 10% to 12.5%.
STT or Securities Transaction Tax
The Securities Transaction Tax (STT) differs from Capital Gains and Dividend Taxes. When you purchase or sell units of an Equity Fund or a Hybrid Equity-Oriented Fund, the Ministry of Finance imposes an STT at 0.001%. However, the sale of Debt Fund units is not subject to STT.
Things to Remember When Looking at Taxes on Mutual Funds
When researching mutual funds taxation, remember the following:
- Mutual funds are taxed based on asset classification and investment duration.
- Equity-oriented funds incur a 20% short-term capital gains tax for holdings up to 12 months. Beyond that, a 12.5% long-term capital gains tax applies for gains exceeding ₹1,00,000.
- Debt mutual funds are taxed according to your income slab for investments up to 36 months. Afterwards, a 12.5% long-term capital gains tax applies.
- Equity-linked savings schemes offer tax deductions of up to ₹1,50,000 annually.
- Dividends from mutual funds are taxable for investors.
- Mutual funds deduct TDS on distributed dividends at a rate of 10% for resident investors and 20% (plus applicable surcharge and cess) for non-resident investors.
How Do Investors Declare Mutual Fund Investments in ITR?
If you’ve made capital gains or losses in a financial year, you must report them by filing ITR Form 2 or 3 (if ineligible for ITR 2). Capital gains from mutual funds are taxed when units are redeemed. Those earning capital gains must file ITR 2, while individuals earning from business or profession must file ITR 3.
Capital gains signify the difference between purchase and sale prices between mutual fund units. If the sale price exceeds the purchase price, it’s a gain; if it’s lower, it’s a loss. The Income Tax Act allows adjusting losses with profits, with long-term losses against long-term gains and short-term losses against both types.
How to Report Capital Gains in ITR?
Individuals receiving capital gains from the sale of equity must file IT returns annually. This can be done online through the official Income Tax Department portal. Here’s a concise, step-by-step guide:
- Log In: Visit the Income Tax Department website and log in with your credentials.
- Navigate: Follow this path: e-File > Income Tax Returns > File Income Tax Returns.
- Select Details: Choose the assessment year, status, and form type. Select ‘Taxable income is more than basic exemption limit’ as the reason for filing.
- Schedules: Select ‘General’ and click on ‘Income Schedule’. Then, choose ‘Schedule Capital Gains’ and select the type of capital assets.
- Short-Term Capital Gains (STCG): STCG from selling listed equity shares is taxed at 15% under Section 111A. If your total taxable income, excluding STCG, is below Rs. 2.5 lakh, the shortfall is adjusted with STCG. The remaining STCG is taxed at 15% plus a 4% cess. Click ‘Add details’ and provide the consolidated amount from the sale of short-term assets along with the Cost of Acquisition (COA).
- Long-Term Capital Gains (LTCG): LTCG from the sale of equity and related instruments is taxed at 10% under Section 112A, with gains up to Rs. 1 lakh tax-free. Provide scrip-wise details, including ISIN, selling price, purchase price, and transaction dates. Click ‘ Add ‘ after entering these details in ‘Schedule 112A’.
- Review and Preview: Confirm the necessary schedules, review Part B TTI, and click ‘Preview Return.’ Then, download the ITR and proceed with the declaration.
- Declaration and Verification: Provide specific details in the declaration tab and click ‘Proceed to Validation’. Verify the ITR electronically or by sending a signed ITR-V printout to the Income Tax Department office in Bangalore. Ensure verification within 120 days of filing.
To Wrap It Up…
Mutual funds taxation is relatively straightforward as these funds are primarily based on the period of holding and whether the scheme is equity—or debt-oriented. However, it can become daunting to calculate everything manually when the tax return deadline is approaching. This is why investors might find it helpful to conduct thorough research about the process of calculating tax on mutual fund redemption.
Frequently Asked Questions About Tax on Mutual Funds
If you’re wondering “is a mutual fund tax-free?”, the answer is no. Earnings from mutual fund investments are taxed as ‘capital gains,’ making it crucial to grasp the tax implications before investing. Additionally, certain situations may allow for tax deductions. However, income from mutual funds is mostly taxable in India.
SIP in Equity Linked Saving Schemes (ELSS) falls under the EEE (Exempt, Exempt, Exempt) or mutual fund tax exemption category. This means that the investment amount, maturity proceeds, and taxes on mutual fund withdrawals are all tax-free, allowing you to invest in ELSS SIPs as tax-free mutual funds.
Tax-cutting on mutual funds refers to reducing the tax burden on the profits (capital gains) investors earn from their mutual fund investments. Various tax-saving mechanisms such as indexation benefits for debt funds adjust the purchase price for inflation, effectively lowering the taxable gain.
Taxation of mutual funds schemes are usually incurred upon unit redemption or sale, not yearly. Yet, dividends received in the current fiscal year are part of your total income and may be taxed if your overall income is taxable.
Under Section 54EA, if you transfer a long-term asset before April 1, 2000, and reinvest in specific bonds within six months. Since this section is no longer in force for new investments, taxpayers now rely on other sections, such as 54EC or 54F, for capital gains tax exemptions.
Section 10 (exempt u/s 10) outlines various tax exemptions in India, such as:
– Agricultural Income (Section 10(1))
– Life Insurance Receipts (Section 10(10D))
– Provident Fund Withdrawals (Section 10(11) & 10(12))
– Gratuity (Section 10(10))
– Leave Encashment (Section 10(10AA))
– House Rent Allowance (HRA) (Section 10(13A))
– Scholarships (Section 10(16))
– Minor’s Income (Section 10(32))
These incomes are subject to specific conditions and limits.
