Tax on Mutual Funds – How Mutual Funds are Taxed?

In July 2024, the mutual fund industry in India crossed the Rs. 60 lakh crore mark – a huge milestone and just another sign of its growing popularity among investors. The Union Budget 2024 introduced many important changes affecting how mutual funds are taxed, so it’s even more important for investors to be aware of how tax rules work for different types of mutual funds.

Let’s look at the mutual fund taxation system and what factors influence it. With mutual fund taxes explained you can get a clear picture of how to optimise your portfolios in a tax-friendly way and save more of your hard-earned money.

Key Factors Affecting Mutual Fund Taxation

Mutual fund taxation is based on the following factors:

1. The type of mutual fund – Tax regulations vary between different types of mutual funds like equity funds, debt funds, and hybrid funds.
2. Dividends – There are two ways investors earn income from their mutual fund investments. The first is dividends, which are profits that a mutual fund distributes to investors from its earnings.
3. Capital Gains – The second type of income is called capital gains. This is essentially the profit earned after redeeming the investments.
4. Holding Period – This refers to how long mutual funds units were held before they were redeemed. Based on this duration, capital gains are classified as either Short-term Capital Gains (STCG) or Long-term Capital Gains (LTCG).

Ways Mutual Funds Generate Profits

There are two ways you can earn income from mutual fund investments – Dividends and capital gains.

Dividends

When the mutual fund distributes profits to its unit holders, the income is called dividends. How much dividend income an investor receives depends on the number of units they hold. Income earned through dividends is classified under the ‘Income From Other Sources’ head and taxed as per the investor’s tax slab. One does not need to redeem their mutual fund investment in order to earn dividends.

Capital Gains

Capital gains are profits earned when selling a capital asset, like mutual funds. At the time of unit redemption, capital gains are calculated by subtracting the purchasing price from the selling price. Based on the holding period, capital gains can be either short-term or long-term. There are broadly three types of mutual funds – equity funds, debt funds, and hybrid funds, and the tax calculation on capital gains depends on fund type and the holding period.

The income tax on mutual funds is calculated differently for dividends and capital gains.

Dividend Taxation in Mutual Funds

Before 2020, the mutual fund houses paid the Dividend Distribution Tax (DDT) to the government before distributing the dividends to the unit holders, so dividends were tax-free in the hands of investors. However, in the Union Budget 2020, the DDT was abolished, and now investors have to pay income tax on dividend income earned under the ‘Income From Other Sources’ category. The dividend income is added to the investor’s total income and taxed as per the slab.

Dividends are also subject to Tax Deducted at Source (TDS). If the total dividends received from mutual funds exceed Rs. 5,000 in a financial year, the asset management company is required to deduct 10% TDS on the dividend payouts under Section 194K. At the time of filing income tax returns, investors can adjust this amount or claim it as a refund.

Capital Gains Taxation in Mutual Funds

Capital gains taxation depends on two factors – 

1. The type of mutual fund
2. How long the investment was held

Depending on the holding period, capital gain can be either – 

1. STCG –  Short-term capital gain (Tax on capital gains is generally higher in the short term)
2. LTCG – Long-term capital gain (Tax on capital gains tends to be lower in the long term)

For an equity mutual fund, STCG tax is applicable if the investment was held for less than 12 months and LTCG tax on an investment held for more than 12 months.

In the case of debt mutual funds, gains after holding units for less than 36 months are considered STCG. Profits earned beyond 36 months are classified as LTCG.

Taxation on Capital Gains for Equity Funds

For a mutual fund to be considered equity-oriented, at least 65% of its total assets must be exposed to equities (stocks). Here’s how STCG and LTCG tax is calculated on equity mutual funds:

STCG Tax

When investors sell their equity fund units within 1 year, capital gains are taxed at 20%. This is an increase from pre 2024 Budget, when STCG were taxed at 15%.

LTCG Tax

If equity mutual funds are sold for a profit after 1 year, gains are considered long-term and taxed at 12.5% without indexation benefit. Holding their investment for over a year is beneficial for investors as the tax rate is much lower, and they also get a tax exemption of Rs. 1.25 lakh. For example, if you earned Rs. 2 lakh LTCG on your equity fund investment in a financial year, only Rs. 75 thousand will be taxed at 12.5%.

Taxation on Capital Gains for Debt Funds

When a fund invests the majority of its assets (65%) in fixed-income securities like bonds, t-bills, and commercial papers, it is considered a debt fund. Here’s how capital gains taxation works on debt funds:

STCG Tax

Gains are considered short-term if you sell your debt mutual fund units within three years. These gains are added to your income and taxed according to your income tax slab rate.

LTCG Tax

Gains are classified as long-term capital gains if you hold your debt mutual fund units for more than three years. If you made the investment on or after 1st April 2023, the LTCG is added to your income and taxed as per the tax slab (no indexation benefit). However, for investments made on or before 31st March 2023, LTCG is calculated as the difference between the selling price of the asset and the indexed cost of the asset and taxed at 20%.

Taxation on Capital Gains for Hybrid Funds

Hybrid funds, as the name suggests, invest in a mix of debt and equity instruments. If a hybrid fund invests more than 65% of its assets in equities, it is taxed like an equity fund. On the other hand, a hybrid fund with less than 65% asset allocation to equities is taxed like a debt fund.

Securities Transaction Tax (STT)

Other than tax on dividends and capital gains, a Securities Transaction Tax (STT) is levied by the government when you buy or sell equity mutual funds or equity-oriented hybrid mutual funds. This tax is set at 0.001% of the transaction value. STT does not apply to debt mutual funds.

Conclusion

The tax on mutual funds is based on four factors – the holding period of the investment (LTCG tax or STCG tax), type of income earned (dividends or capital gains), type of mutual fund (equity, debt, equity-oriented hybrid, or debt-oriented hybrid fund), and the investor’s income tax slab. After learning about mutual fund taxation you can make tax-efficient decisions and minimise your tax liabilities.

If you are looking to save some taxes by investing in mutual funds, you can look at Equity Linked Savings Schemes (ELSS). These schemes are also called tax-saver mutual funds because under Section 80C of the Income Tax Act, they allow you to reduce your taxable income by Rs. 1.5 lakh per financial year. These schemes focus on equity instruments and come with a lock-in period of 3 years, so only LTCG tax is applicable to these funds. Their high returns make them suitable for aggressive investors with a long-term perspective.

Taxes can take a significant chunk out of your investment returns, so consulting with a tax advisor can prove to be a wise decision. A tax advisor can help you choose not only the most tax-efficient funds but also funds that work in tandem with your financial goals, situation, and investment horizon. They can help you maximise your deductions and exemptions that minimise your overall tax liabilities while guiding you through the changing tax regulations.

FAQs

How is the tax on mutual fund withdrawals calculated?

The tax on mutual fund withdrawals is known as capital gains. It is the profit that is calculated by subtracting the purchase price from the selling price. Different types of mutual funds (equity, debt, and hybrid) are taxed differently, and based on how long the funds were held, a short-term capital gains tax or long-term capital gains tax rate is determined. For example, capital gain on equity funds held for less than 1 year is classified as STCG and taxed at 20%.

What are tax-free mutual funds?

No mutual funds are completely free of tax. If you redeem an equity mutual fund investment after holding it for 1 year and the LTCG is less than Rs. 1.25 lakh, then you need not pay any taxes on the profit due to the exemption limit. There are, however, mutual funds that let you save tax. These funds are called Equity Linked Savings Scheme (ELSS), and under Section 80C of the Income Tax Act, they allow you to claim a deduction of up to Rs. 1.5 lakh.

Are there any tax-saving mutual fund options available?

Yes! Equity Linked Savings Schemes, or ELSS are tax-saving mutual funds that allow investors to claim a tax deduction of up to Rs. 1.5 lakh under Section 80C of the Income Tax Act.

Are dividends from mutual funds taxable?

Yes, dividend income is classified under the head ‘Income from Other Sources’. They are added to your yearly income and taxed as per your tax slab.