A guide to Mutual Fund taxation

Understanding mutual fund taxation is critical to making sound and informed investing decisions. Investing in mutual funds not only provides a good opportunity to get inflation-beating returns compared to other options like FDs, RDs, etc. but also is a much more tax-efficient vehicle.

Let’s first get a quick recap on how your investments in FDs are taxed to have a better understanding of its tax-inefficient nature and then move on to understand more about the taxation structure of mutual funds.

FD taxation structure

The interest you earn on your FDs every year is added to your income and taxed at your income tax slab rate. You will be taxed irrespective of whether you realize the interest or not. However, in mutual funds, even if the value of your investment increases and you do not redeem it – you will not be liable to pay any tax on that.

This is one of the biggest benefits of investing in mutual funds compared to FDs. FDs by nature are taxation-inefficient and if you look at their after-tax returns of them – you will be surprised to see how little they yield compared to other options.

Mutual Fund Taxation

Equity Mutual Funds

Equity funds are mutual funds that invest at least 65% of your money in equity and equity-related instruments:

• Short-term – If your holding period is less than 12 months. i.e you sell your investments before a year from the time of purchase, your gains are taxed at 15%.
• Long-term – If your holding period is more than 12 months. i.e you sell your investments anytime after a year from the time of purchase, you are taxed at 10% for gains over and above Rs. 1 lakh. For e.g. If you realized a profit of Rs. 1,10,000 by holding the mutual fund units for over 1 year then you will pay only Rs. 1,000 in taxes i.e. 10% of (Rs. 1,10,000 – Rs. 1,00,000) since gains up to Rs. 1 lakh is exempted from being taxed.

(Mutual fund taxation for equity funds is the same as the taxation for stocks)

Debt Mutual Funds

Debt funds are mutual funds that park most of your assets in debt-related instruments, a minimum of 65% of their portfolio.

• Short-term – If the holding period of your mutual fund units is less than 36 months. I.e you sold your investments in the mutual fund before 3 years from the inception of your investment, you are taxed according to your tax slab on your capital gains
• Long-term – If the holding period of your mutual fund units is more than 36 months. i.e you sell your investments in the mutual fund after 3 years from the time of purchase, you are taxed at 20% with an allowance of indexation on your capital gains. Indexation refers to adjusting the cost of purchase for inflation.

For e.g. Let’s say you invested in a debt mutual fund with a NAV of Rs. 100 on 1st January 2019. After 3 years, on 2nd January 2022, the NAV was INR 150. Since the holding period is >3 years, you will pay a long-term capital gain on this. However, your capital gains tax will be calculated after adjusting the original NAV of Rs. 100 for inflation. There is a formula to calculate the indexed cost of acquisition which basically factors in inflation and increases the cost of purchase thereby reducing the capital gains.

So, if the indexed cost of acquisition was Rs. 110, then your capital gains will be 20% of INR (150 – 110) of 8 rupees. 

Mutual fund taxation on dividends under the ‘Income distribution cum Capital Withdrawal’ option

Any dividends received by the mutual fund schemes from the company in their portfolio are not mandated to be distributed to the investors. Mutual funds under a separate option called ‘Income Distribution cum Capital Withdrawal’ (IDCW) may pay out dividends to the investors – however, any such payouts are their sole discretion and there is no guarantee that the fund will be able to continue to provide it regularly.

Dividends received in the hands of the investors under the IDCW option are taxed at the individual’s marginal tax slab rate. Hence, it is always advisable to choose the ‘Growth’ option since its more tax efficient. Under the ‘Growth’, any dividends or interest received by the mutual funds is reinvested back into the scheme which gets reflected in the form of a higher NAV.

Taxation Benefits under Section 80C of the Income Tax Act

Certain mutual fund schemes can also provide investors with the benefit of getting tax exemption under section 80C of the Income Tax Act.

Equity Linked Saving Schemes (ELSS) are a special category of mutual funds that are eligible for deduction under the 80C Act. These are primarily equity schemes that invest at least 65% of their portfolio in equity and equity-related instruments. Some salient points to note are below:

1. The scheme has a lock-in period of 3 years
2. The benefit is available for up to Rs. 1.5 lakhs per taxpayer per year
3. This is one of the many eligible investments under Section 80C which means that if you have exhausted your Rs. 1.5 lakhs limit by investing in other instruments like PPF etc. then you will not be able to claim any further deduction
4. If you are investing via the SIP route in the ELSS scheme, every instalment is subject to a 3-year lock-in period from the date of their respective investment

Conclusion

Taxation is a critical component of any investment option. Therefore, it’s always good to have a thorough understanding of the mutual fund taxation regime to help you take a more informed decision.