Mutual funds have proven themselves to be the most chosen investment avenue in recent times. The diversified nature of mutual funds appeals to people who want to have minimum risk and maximum return. However, Mutual funds are also subjected to tax implications that affect the returns.
Understanding the tax on mutual funds will help make better investment decisions. This article provides:
- Detailed information about the tax on mutual funds.
- Covering different types of mutual funds.
- Tax treatment on income gains.
- Strategies to optimize tax efficiency.
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What is Tax on Mutual Funds?
Tax on mutual funds refers to the taxation rules and regulations applied by the government on the income generated from mutual fund investment. The tax slabs depend on the types of mutual funds, investment duration, and the type of income received.
Factors Determining Tax on Mutual Funds
1. Types of Mutual Funds
The type of mutual fund is one of the key factors that determines the tax on mutual funds. Mutual funds are categorized into three funds – Equity, Debt, and Hybrid, each with different tax implications.
2. Holding Period
The holding period means the duration of the investment; this includes short-term investment and long-term investment. The tax on mutual funds is significantly affected by the length of the investment period.
3. Dividend Distribution
The tax implications on mutual funds have changed after 2020. As per the 2020 Finance Act, dividends are now considered as taxable income. The income generated from mutual funds will be considered in the total income of the individual.
4. Investor’s Tax Status
The status of an individual also impacts the tax implications for mutual funds. The individual’s national status, i.e., if he is a national resident or NRI, also affects the tax treatment.
5. Indexation Benefit
Indexation is a technique where we adjust the cost of the debt mutual fund as per inflation. It benefits by reducing the taxable gains by accounting for inflation over the holding period. This method significantly impacts and reduces tax on mutual funds.
6. Tax-saving Mutual Funds
Investments under ELSS (Equity Linked Saving Scheme) are subjected to tax deductions up to ₹1.5 lakh as per section 80C of the Income Tax Act. ELSS investment has to be locked for two or three years and taxed as long-term capital gains.
Understanding Tax on Mutual Funds
1. Types of Mutual Funds and Their Taxation
There are 3 types of mutual funds: Equity, Debt, And Hybrid. Each type has a different tax slab based on the investment period and the nature of the fund.
Equity Mutual Funds
Equity funds are invested in stocks and subjected to tax implications per the investment period.
- Short-Term Capital Gains (STCG): If the equity mutual fund is sold within 12 months of investment, then they are considered as short-term income. These short-term gains are taxed at 15%.
- Long-Term Capital Gains (LTCG): Opposite to the short-term gains, if the investor holds the investment for more than 12 months, then the investment will be considered for long-term income. If the long-term capital gain on mutual funds goes beyond 1 lakh Rupees, then they are taxed at 10%.
Debt Mutual Funds
Debt Mutual funds are invested in fixed-interest-paying instruments such as T-bills and bonds.
- Short-Term Capital Gains (STCG): For an investment to be considered a short-term gain from debt mutual funds, the investment must be for a maximum of 3-year period. The profit earned during this period will be added to the investor’s total income and will be taxable.
For an investment to be considered a short-term gain from debt mutual funds, the investment needs to be for a maximum of 3-year period. - Long-Term Capital Gains (LTCG): In this case, if the investment period is more than 3 years, they will be considered under long-term capital gains. They will be added to investors’ total income, and the mutual fund gained income will be taxed at 20%.
Indexation benefits are applicable for long-term capital gains, which means the purchasing cost will be adjusted as per inflation. Due to Indexation, the taxable income will be reduced.
Hybrid Mutual Funds
A hybrid mutual fund is a mixture of debt and equity. The tax slab for hybrid mutual funds is considered based on their exposure.
- Equity-Oriented Hybrid Funds: If the invested amount has 65% or more exposure, the amount will be considered equity for taxation.
- Debt-Oriented Hybrid Funds: On the other hand, if the exposure of the fund is less than 65%, it is considered a debt fund for taxation.
2. Dividend Distribution Tax (DDT)
Before 2020, the dividends from mutual funds were subjected to DDT, which means the company paid the taxes on the income before the dividend was distributed.
Post-Budget 2020, the DDT was nullified, and dividends received by investors are now taxed as per their income tax slab. Because of this new policy, the companies are free from tax on dividends, and investors bear the burden.
3. Tax-Saving Mutual Funds
Equity-Linked Savings Schemes (ELSS) are mutual funds designed to provide tax benefits as per Section 80C of the Income Tax Act. Investments under ELSS (Equity Linked Saving Scheme) are subjected to tax deductions up to ₹1.5 lakh as per section 80C of the Income Tax Act. ELSS investment must be locked for two or three years and taxed as long-term capital gains, the shortest among all tax-saving instruments.
4. Systematic Investment Plan (SIP) and Taxation
SIP, or Systematic Investment Plan, is a systematic approach to investing in mutual funds, where investors regularly deposit a pre-determined amount of money. The SIP tax slab is based on each installment’s holding period.
For equity funds, every installment is considered a new investment, and the holding period is calculated accordingly. For debt funds, the same principle applies, with each installment subject to STCG or LTCG based on its individual holding period.
5. Tax Implications of Switching Between Funds
Switching between mutual funds is treated as a sale of units from the original fund and a purchase of units in the new fund. This switch triggers capital gains tax based on the holding period of the units being sold. Investors should consider the taxation factor before switching to other options.
6. Indexation Benefits
Indexation is a technique where we adjust the cost of the debt mutual fund as per inflation. It benefits by reducing the taxable gains by accounting for inflation over the holding period.
By applying the Cost Inflation Index (CII), investors can reduce their taxable profits, lowering their tax outgo. This benefit is particularly significant for long-term investors in debt funds.
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FAQs
How much tax do I pay on mutual funds?
The tax you pay on mutual funds depends on the type of fund and holding period: equity funds held for less than one year incur a 15% tax on short-term gains, while long-term gains over one year are taxed at 10% for gains exceeding INR 1 lakh annually. Debt funds held for less than three years are taxed according to your income tax slab, and those held for over three years incur a 20% tax with indexation benefits.
How to avoid tax on mutual funds?
To minimize tax on mutual funds, invest in Equity-Linked Savings Schemes (ELSS) for tax deductions under Section 80C, and hold your investments long-term to benefit from lower tax rates on long-term capital gains and indexation benefits for debt funds.
Is SIP in mutual funds tax-free?
No, SIPs in mutual funds are not tax-free; each SIP installment is treated as a separate investment for tax purposes, with equity SIPs subject to short-term (15%) or long-term (10%) capital gains tax depending on the holding period and debt SIPs taxed based on the investor’s income tax slab for short-term gains or 20% with indexation for long-term gains.
What is Tax on Mutual Funds?
Tax on mutual funds refers to the taxation rules and regulations applied by the government on the income generated from mutual fund investment. These tax implications can vary based on the duration of the investment, the type of mutual fund, and the type of income received.
Final Statement
Understanding the tax on mutual funds is essential for maximizing returns and planning effectively. Each type of mutual fund—equity, debt, and hybrid—has distinct tax treatments based on the duration of the investment, the type of mutual fund, and the type of income received.
Additionally, investors must be aware of changes in tax regulations, such as the abolition of the Dividend Distribution Tax and the introduction of a tax on dividends as per individual income tax slabs.
By carefully planning investments and considering tax-efficient options like Equity-Linked Savings Schemes (ELSS) and utilizing indexation benefits for debt funds, investors can optimize their tax liabilities and enhance their overall investment returns.
I hope this post on tax on mutual funds has been informative. Mention your doubts and suggestions in the comment box