Mutual funds are typically regarded as a suitable investment option because they help you reach your financial
objectives. A significant benefit of mutual funds is that they are tax-efficient investment vehicles. However,
profits from these investments are taxed like other asset-class investments as they are a form of passive income.
Therefore, before investing in mutual funds, you should know how your earnings are taxed.
How Are Mutual Funds Taxed?
Four factors determine your mutual fund taxation. These include:
1. Type of Funds: There are two taxable categories of mutual funds - equity and non-equity funds.
2. Income Distribution cum Capital Withdrawal (IDCW) Payouts: When NAV units are sold at a price higher than that of purchase, the realised gains are credited to an Equalisation Reserve Account which is part of the overall assets. IDCW payouts can be made from this account at the discretion of the trustees. The amount received by investors is considered income from other sources and taxed in the hands of the investors.
3. Capital Gains: Capital gains are appreciation investors earn from selling their capital assets for a higher value.
4. Holding Period: The holding period, in India, determines the tax gains for an investor. A higher holding period amounts to lower taxes and vice versa.
Let’s take a closer look at how various categories of mutual funds are taxed.
Mutual Fund Taxation For Capital Gains Earned By Residents
The taxes for capital gains are determined by the tax rates of equity and non-equity funds and their respective holding periods, which may be long-term or short-term.
● Equity Funds: An equity-oriented mutual fund scheme allocates at least 65% of the total proceeds of such funds towards investment in the equity shares of domestic companies listed on a recognised stock exchange. The capital gains are taxed based on the holding period in the following way -
- Short-Term Capital Gains (STCG): According to Section 111A of the Income-tax Act, 1961 (‘Act’), STCG tax is levied at a rate of 15% (plus applicable surcharge and cess) on the transfer of equity-oriented mutual funds held for a period less than 12 months.
- Long-Term Capital Gains (LTCG): When you sell your stock fund units after holding it for a period of at least 12 months, you realise long-term capital gains. Aggregate LTCG of up to INR 1 lakh each year arising from the sale of listed equity shares, units of an equity-oriented fund, or a unit of a business trust is tax-free. Any long-term capital gains over this amount are subject to a 10% (plus applicable surcharge and cess) LTCG tax with no indexation benefits under section 112A of the Act.
Taxation for hybrid equity-oriented funds is calculated in the same manner as equity funds.
* Tax rates are exclusive of surcharge and health and education cess.
● Non-Equity Funds: Mutual fund portfolios with less than 65% equity exposure are non-equity or debt funds. Taxation for the capital gains for these funds also varies according to the holding periods:
- Short-Term Capital Gains: With a holding period of lesser than 36 months, STCG for non-equity funds are taxed as per your taxable income and tax slab.
- Long-Term Capital Gains: When you sell non-equity fund units with a holding period of 36 months and more, you realise long-term capital gains. After indexation, these gains are subject to a tax of 20% (plus applicable surcharge and cess).
Taxation for hybrid non-equity-oriented funds is calculated in the same manner as non-equity funds.
Indexation: An Instrument For Tax Benefits
Indexation, as mentioned above in long-term capital gains, is a method of adjusting an investment's purchase price to consider the impact of inflation. A higher buying price results in smaller profits, effectively resulting in a lower tax. Therefore, you can reduce your taxable income by lowering your long-term capital gains with the help of indexation.
Understanding Taxation On Income Distribution cum Capital Withdrawal (IDCW)
The dividends received from mutual fund profits were distributed to investors some years ago after paying a Dividend Distribution Tax (DDT). The mutual fund house paid the DDT, and what you received was a tax-free payout. However, from 01 April 2020, taxation on ‘dividends’, or what is now known as IDCW, has changed. According to new laws, the payouts received from mutual funds will get added to your taxable income. Hence, you will be taxed according to your income tax slab.
Tax Benefits With Equity Linked Savings Scheme (ELSS)
ELSS is a mutual fund scheme focusing primarily on equity investments. Section 80C of the Income Tax Act, 1961 makes investments in ELSS mutual funds up to INR 1.5 lakh, tax deductible. You will have to invest in the fund every financial year to leverage this tax deduction. ELSS requires a minimum lock-in period of three years, a short span compared to other investment instruments. This indicates that you can only sell your investment three years after the date of acquisition. Any sale of investments after the lock-in period should qualify as a long-term capital gain.
However, you might consider holding on to your investments for as long as possible to maximise the earnings potential from ELSS funds.
Now that you know all the taxation aspects of mutual funds, you can make smarter decisions while investing in them. The longer you hold on to these fund units, the better tax benefits you could get. This can significantly benefit investing and creating potential wealth while efficiently managing your taxes.
An investor education initiative by ICICI Prudential Mutual Fund Visit www.icicipruamc.com/note to know more about the process to complete a one-time Know Your Customer (KYC) requirement to invest in Mutual Funds. Investors should only deal with registered Mutual Funds, details of which can be verified on the SEBI website http://www.sebi.gov.in/intermediaries.htmlFor any queries, complaints & grievance redressal, investors may reach out to the AMCs and/or Investor Relations Officers. Additionally, investors may also lodge complaints on http://scores.gov.inif they are unsatisfied with the resolutions given by AMCs. SCORES portal facilitates you to lodge your complaint online with SEBI and subsequently view its status.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.