Mutual Fund Taxation - How Mutual Funds are Taxed?

An Overview of Mutual Fund Taxation

Mutual Funds in India are a favoured investment option due to their potential for delivering substantial returns. However, the gains accrued through these funds are subject to taxation. In 2018, late Finance Minister Arun Jaitley reintroduced the tax on long-term capital gains. Before 2018, if you held onto your investments for a year or more, you did not have to pay taxes.

Presently, it is impossible to avoid paying taxes on capital gains. Some strategic planning, though, can help in achieving tax efficiency. This has to start with understanding how capital gains are taxed.

Factors to Determine Tax on Mutual Funds

The taxation on mutual funds depends on several important factors and understanding these can help you plan better and maximise your post-tax returns. Here are the factors to know about:

1. Type of Fund

The first important thing to know is the type of mutual fund you are choosing as each mutual fund is taxed differently.

2. Dividends

If a mutual fund declares dividends, they are added to your taxable income and taxed as per your income tax slab. There is no separate tax rate for dividends.

3. Capital Gains

When you sell your mutual fund units at a profit, it is considered capital gains. Short-term and long-term capital gains are taxed differently depending on the type of fund.

4. Holding Period

The duration for which you hold your investment directly impacts taxation. Longer holding periods usually attract lower tax rates on capital gains. For instance, equity funds held for more than one year enjoy favourable long-term capital gains tax treatment.

It is essential to consider these factors so that you can plan your investments effectively, reduce tax liability, and grow your wealth.

Capital Gains Tax on Mutual Funds

Capital gains arising from Mutual Fund investments are subject to taxation, determined by various factors such as fund type, holding period and the nature of gains, be it short-term or long-term.

How Do Mutual Funds Generate Profits?

Mutual Funds generate profits in two main ways:

1. Capital gains

2. Dividend income

Capital gains tax on mutual funds arise when you redeem your mutual fund units for more than your purchase price. These gains are realised and taxed only upon redemption. On the other hand, dividend income is paid out from the fund’s distributable surplus and is taxable as soon as it’s received.

While previous regulations imposed Dividend Distribution Tax (DDT) on fund houses, current rules require Dividend income to be reported under “Income from Other Sources.” If annual dividends exceed ₹5,000, a 10% TDS under Section 194K is applicable, which can later be adjusted in your annual tax filing.

Fund Types and Corresponding Tax Rates:

1. Equity Funds and Hybrid Equity-Oriented Funds: For holding periods that are shorter than 12 months, the tax rate is 15%. For more than 12 months, the tax rate is 10%, but it's exempted for gains up to Rs 1 lakh.

2. Debt Funds and Hybrid Debt-Oriented Funds: For holding periods that are shorter than 36 months, you are taxed as per the Tax Slab Rate. For more than 36 months, the tax rate is 20%.

Understanding these categories and their corresponding tax rates is crucial for investors, as it directly impacts the tax liabilities arising from their Mutual Fund investments. More importantly, having an idea about funds and their tax rates helps in making strategies to become tax efficient.

Taxation of Dividends Provided by Mutual Funds

Under current tax rules, dividend income from mutual funds is treated as part of your regular income and taxed according to your income slab. While the Dividend Distribution Tax (DDT) has been abolished, the fund house deducts 10% TDS on dividends exceeding ₹5,000 per financial year.

You can claim this TDS and adjust it against your total tax liability during income tax filing. Since dividends can alter your taxable income, plan investments such that the payout aligns with your tax bracket. This will help in efficient tax planning while maximising portfolio returns.

Taxation of Capital Gains Provided by Mutual Funds

Capital gains on mutual funds depend on the holding period and fund type. For equity funds, STCG applies if sold within 12 months; LTCG applies if held longer. For debt mutual funds, units purchased on or after 1 April 2023 are always taxed as STCG, irrespective of the holding period, and taxed as per your income slab. For debt units bought before this date, the old LTCG rule of 36 months with indexation still applies.

The applicable tax rate varies based on fund classification (equity, debt, or hybrid). Gains from mutual fund redemptions should be reported during the same fiscal year in which the redemption occurs.

Taxation of Capital Gains Provided by Equity Funds

For equity or equity-oriented hybrid funds, units sold within 12 months attract Short-Term Capital Gains (STCG) tax at 15%. Once the holding crosses 12 months, any gain up to ₹1.25 lakh is exempt, and the excess is taxed at 12.5%, without the benefits of indexation.

Note that STT (Securities Transaction Tax) is applied at 0.001% on equity unit redemptions. This tax structure rewards long-term investing in equities by providing relief on gains up to a threshold.

Taxation of Capital Gains Provided by Debt Funds

Debt mutual funds follow different rules. Gains realised within 3 years are treated as STCG and added to your taxable income, being taxed at your slab rate. After holding for over 3 years, gains are classified as LTCG, which are still taxed at slab rates; there is no exemption or indexation benefit.

Though indexation does not apply now, earlier investments would have been eligible. Also, STT does not apply to debt fund redemptions, making their tax structure distinct from equity funds.

Taxation of Capital Gains Provided by Hybrid Funds

Tax treatment of hybrid funds depends on their equity exposure. If a hybrid fund's equity portion exceeds 65%, it is taxed like equity funds: STCG at 15% for redemptions under 12 months and LTCG at 12.5% above ₹1.25 lakh post 12 months.

Hybrid funds with less than 65% equity are taxed like debt: gains under 3 years are taxed as STCG at slab rates, and gains over 3 years as LTCG at the slab rate without indexation. Always check the fund’s equity allocation before considering tax implications.

Taxation of Capital Gains in SIPs

Systematic Investment Plans (SIPs) introduce a First-In-First-Out (FIFO) approach in determining the tax treatment of MF units redeemed. The units purchased first through SIPs and held for over a year are considered long-term holdings, with no tax on gains below Rs 1 lakh. Units from the second month onwards, attract a flat 15% STCG Tax.

Securities Transaction Tax

In addition to taxes on dividends and capital gains, Securities Transaction Tax (STT) is levied on the purchase or sale of units of equity funds or hybrid equity-oriented funds. It is typically 0.001% of the transaction value, excluding debt fund transactions.

Declaring Mutual Fund Investments in ITR

Proper disclosure is essential in the Income Tax Return (ITR), when redeeming MF investments.

Strategies to Reduce Capital Gains Tax on Mutual Funds

Tax Harvesting

Utilising tax harvesting involves selling a portion of Equity Mutual Fund units annually to realise long-term gains and subsequently reinvesting the proceeds into the same fund. By following this method, investors can keep their long-term returns below the Rs 1 lakh threshold, thus avoiding long-term capital gains tax upon redemption.
For instance, if an investor invested Rs 3 lakh in an Equity Fund in January 2024, with a 20% annual return and redeemed it in February 2025 for Rs 3.60 lakh, the capital gains of Rs 60,000 remained tax-free as it stayed below the Rs 1 lakh threshold for that financial year.

Capitalise on Your Losses

This approach involves booking long-term capital losses to offset against other long-term capital gains, effectively reducing the capital gains tax burden. For instance, if an investor faced a loss of Rs 40,000 on an investment valued at Rs 1.6 lakh in January 2024, they could offset this loss against any long-term capital gains booked in the same year. By doing so, investors can reduce payable capital gains tax.

Conclusion

While it is impossible to entirely avoid paying taxes on Mutual Fund gains, understanding tax implications and using strategic planning can help minimise tax liabilities. Embracing Tax Harvesting is an effective way to reduce Capital Gains Tax on Mutual Funds.
However, investors should consult financial advisors or tax experts to tailor these strategies to their specific financial goals and investment objectives, especially if they are planning to capitalise on their losses.