Mutual Funds

Tax on Mutual Funds – How are Mutual Funds Taxed?

Mutual fund investments are one of the best investing avenues. An investor should lookat the tax treatment on mutual fund investments. Taxation on mutual funds depends on what type of funds you have invested in; how long have you have invested for and the income tax slab you belong to.

Source of income from mutual funds needs to be understand first before we understand about taxation.

Earnings in mutual funds can be from:

  1. Regular dividends
  2. Capital Gains

Dividends

Dividends are distributed from the profits of the company. When the companies have surplus cash, they may distribute them with the investors in the form of dividends. Investors earn the dividends in proportion to the mutual fund units held by them.

Capital Gains

Capital gain is the profit received if the selling price is higher than purchase price of the financial instrument held. To understand it better, it is the gain realized when price of mutual fund units appreciates.

Taxation on dividends

Dividends offered by any mutual fund schemeare taxed only after they are declared. Dividends will be taxed according to an individual’s tax slab rate.

Taxation on capital gains

Tax on capital gains depends on the investment period and category of mutual fund. Investment period means for how long the investor has invested in the mutual funds. To understand how taxes are levied on capital gains we need to know that capital gains are divided into 2 parts:

  1. Short term capital gains
  2. Long term capital gains

Both these gains have different time-period for different categories of mutual funds:

Different tax rates apply for short-term and long-term capital gains.

Taxation on capital gains from equity funds

Equity funds have exposure to equity of more than 65%. When you redeem your investment in equity mutual funds within one year, the tax rates will be 15%. The holding period of 1 year or less refers to Short Term Capital Gain (STCG)

 When the investment from equity funds is redeemed after 1 year then such a case is referred to as Long Term Capital Gain (LTCG). In this scenario, gains up to one lakh are tax exempt. Gains exceeding Rs one lakh are taxed at 10% and no benefit of indexation is provided.

Taxation on capital gains from debt funds

The portfolio exposure to debt exceeds 65% in debt mutual funds. Short term Capital Gains in debt mutual funds happens when the holding period is within three years. These gains are added to your taxable income and the investor must pay tax according to the income tax slab rate.

Long term capital gains on debt mutual funds are realized when you sell mutual fund units after three years from the date of purchase. These gains are taxed at 20% after indexation. Cess and surcharge are also applied on these investments.

Taxation on hybrid mutual funds

The rate of taxation on hybrid mutual funds depends upon the equity exposure of the portfolio. If the equity exposure exceeds 65% then in such a scenario, they are taxed as equity funds are taxed. Whereas, if the debt exposure exceeds 65% then taxation rules of debt mutual fund apply.

In case of arbitrage funds, the funds are taxed like equity funds. Arbitrage funds should be consideredfor investing in place of short-term debt mutual funds for investors who are in high income tax bracket.

Summarizing all the rates of taxation on capital gains:

How does taxation apply on capital gains when investment is done through SIP?

SIP (Systematic Investment Plan) is a way to invest in mutual funds. SIP gives the flexibility of spreading your investments periodically. The investors invest a fixed amount regularly in a mutual fund scheme. Regularly here means how frequently the investor can invest in the mutual fund scheme. The investors can choose to invest monthly, weekly, yearly, quarterly.

Investing in an equity mutual fund:

Let us suppose that you are investing in an equity mutual fund scheme where at every investment you receive certain mutual fund units. Now, you decide to redeem the investment after 14 months of investing. In such a case, the units held for long term,giveslong term capital gain. If the gain is up to Rs one lakh then no tax is charged. If it is more than one lakh then a tax of 10% is charged. While in the case of the units held for less than one year which represents short term capital gain are taxed at 15%. There is also applicable cess and surcharge which needs to be paid above the tax rate.

Investing in debt mutual fund:

Let us suppose that you are investing in a debt mutual fund scheme where at every investment you receive certain mutual fund units. Now, you decide to redeem the investment after 38 months of investing. In such a case, the units held for long term, which means more than 36 months in debt funds, are charged at 20% tax after indexation. While in the case of short-term capital gains which means investment for less than 36 months, the gains are taxed according to the investor’s tax slab. There is also applicable cess and surcharge which needs to be paid above the tax rate in case of long-term capital gain.

Securities Transaction Tax (STT)

There is another type of tax called STT which applies on selling mutual fund units of an equity fund or hybrid equity fund. The rate is 0.001%. STT on buying or selling of debt funds is not applicable.

Conclusion:

Mutual fund investments done for a longer period are tax efficient. Plan your investments for a long time to enjoy the benefit lower taxation and power of compounding.

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