Income tax on mutual funds: Capital gain, equity, debt

What is mutual fund?

The first thing you should know about mutual funds is that they pool money from many different investors to purchase a diversified portfolio of stocks, bonds, and other securities. The value of your mutual fund investment is determined by the performance of the underlying securities in the fund’s portfolio.

What is income tax on mutual funds?

Taxes that need to be paid on sale of mutual fund units at a gain. Investors opting for IDCW (Income Distribution/Capital Withdrawal) of a mutual fund scheme will be subjected to taxes as per their applicable taxation slab rates.

Income tax on mutual funds: Taxation on debt

From April 1, 2023 the income from debt-oriented mutual funds are taxed at the investor’s applicable income tax rate. Previously, the income from debt mutual funds with a holding period of over 3 years were considered as long term capital gains and were taxed at a rate of 20% with indexation benefits as per section 112 of the Income Tax Act. 

Types of mutal funds

There are two main types of mutual funds: taxable and tax-exempt. A taxable mutual fund is one that generates capital gains and dividends. The income generated by these mutual funds is subject to federal and state income tax unless the mutual fund is held in a tax-advantaged account.

On the other hand, tax-exempt mutual funds are those that invest in municipal bonds, which state and local governments issue to finance public projects. The income generated by these bonds is generally exempt from federal and state income tax. Alternative minimum tax (AMT), a separate tax system that applies to certain high-income taxpayers, may still apply to tax-exempt mutual funds.

Factors that determine tax on mutual funds

There are several factors that determine the tax on mutual funds, including

Fund type: Taxes may be levied on two types of mutual funds: debt-oriented and equity mutual funds.

Dividend:  Mutual fund companies distribute dividends to investors as a portion of their profits. It does not require the investor to sell their assets.

Capital gains: When investors sell their capital assets for a higher price than their cost, the profit is called a capital gain.

Holding period: According to Indian income tax regulations, if an investment is held for a long period, the investor will be liable for a lower tax amount. The holding period can therefore affect the tax rate on capital gains, with a longer holding period resulting in a lower tax liability.

Taxation on dividends

As of March 31, 2020, the Finance Act of 2020 has eliminated the Dividend Distribution Tax (DDT) on mutual fund dividends. This means that investors are now required to pay taxes on their dividend income from mutual funds as part of their “income from other sources” according to their income tax bracket. 

In addition, a TDS (tax deducted at source) of 10% must be applied to dividends distributed by mutual funds to investors if the total amount paid to an individual investor exceeds Rs 5,000 in a fiscal year, as per section 194K. AMCs can deduct TDS for investors, allowing them to pay only the remaining balance when filing taxes.

How are mutual fund gains taxed?

The gains from mutual funds are classified as short term or long term capital gains for units.

What is the capital gains tax on mutual funds?

Mutual fund capital gains are taxed based on the type of fund and the duration of the holding period. Capital gains are divided into long-term capital gains (LTCG) and short-term capital gains (STCG) based on the holding period of the asset. 

For tax purposes, the distinction between long and short holding periods differs between equity and debt schemes. For equity-oriented schemes and debt-oriented schemes, the holding period must be at least 12 months for capital gains to be considered long-term. The following table summarises the holding periods required for capital gains to be classified as long-term or short-term.

 

Fund Type	LTCG Holding Period	STCG Holding Period
Equity Funds	More than 12 months	Less than 12 months
Hybrid Funds	More than 12 months	Less than 12 months
Debt Funds	Deemed to be short term irrespective of the holding period	Less than 36 months

Income tax on mutual funds: Taxation on equity

A mutual fund that invests at least 65% of its corpus in Indian equities or equity-related instruments is considered an equity-oriented scheme for tax purposes. At the same time, all other funds are treated as debt-oriented schemes. 

Long-term capital gains (LTCG) on the sale of equity shares or equity-oriented mutual fund units were previously exempt under section 10(38) of the Income Tax Act, but this changed in 2018. Currently, LTCG on mutual funds (equity-oriented schemes) is taxed at a rate of 10% on capital gains above Rs 1 lakh as per section 112A of the Income Tax Act. For example, if you have an LTCG of Rs 1,20,000 from an equity-oriented scheme in a fiscal year, your tax will be calculated on the Rs 20,000 at 10% (plus applicable cess and surcharge). 

Short-term capital gains (STCG) on the sale of units of equity-oriented mutual funds are taxed at a rate of 15% as per section 111A of the Income Tax Act. For example, if you have STCG of Rs 1,30,000 from an equity-oriented scheme in a fiscal year, your tax will be calculated on the full Rs 1,30,000 at 15% (plus applicable cess and surcharge), since the Rs 1 lakh exemption for LTCG does not apply to STCG.

How can I reduce my tax liability on mutual funds?

Mutual funds allow set off and carry forward of losses against gains subject to certain conditions. Investors can potentially benefit from lower taxes by taking advantage of these provisions.

FAQs

Can mutual fund investments help me get a rebate on income tax?

Tax-saving mutual funds such as Equity Linked Saving Schemes (ELSS) and other tax-saving schemes may allow you to claim tax benefits under Section 80C of the Income Tax Act. This could potentially save you around Rs 46,800 on taxes each year. However, ELSS have a minimum lock-in period of three years.

Are wealth taxes applicable to mutual fund investments?

No, mutual funds and other financial assets are generally exempt from wealth taxes according to the Wealth Tax Act. Therefore, you would not need to pay wealth tax on your mutual fund investments.

What is Section 54EA regarding capital gains tax exemptions?

Section 54EA provides for an exemption from the capital gains tax, as calculated under Section 54F, if a long-term capital asset that was transferred before April 1, 2000, is invested in certain specified bond shares within six months of the transfer date.

What are tax-saving mutual funds?

Tax-saving mutual funds, which are also referred to as Equity Linked Saving Schemes (ELSS), provide an investment opportunity that can result in tax savings under Section 80C of the Income Tax Act. These funds may help you save on taxes by allowing you to claim deductions on your investment.

 

Got any questions or point of view on our article? We would love to hear from you. Write to our Editor-in-Chief Jhumur Ghosh at [email protected]