Understanding mutual fund taxation

When it comes to investing in mutual funds, you cannot overlook the taxes associated with them. However, we say that’s the glass-half-empty way of looking at things. The glass-half-full version? The more tax you need to pay, the more money you’re making, right?

Let’s understand how mutual fund taxation in India works, and if there are ways to minimise your tax liability.

How do mutual funds generate returns?

Mutual funds invest in stocks, debt securities, or other instruments to generate profit for investors. If you are a unit holder, these profits are distributed to you through two methods, each of which attracts a different type of tax. These are:

• Capital Gains: If you buy a mutual fund unit and sell it at a higher price, the profit generated is considered a capital gain and will attract capital gains tax.
• Income Distribution cum Capital Withdrawal (IDCW): As a unit holder in a mutual fund, you will receive IDCW that is declared by fund houses subject to availability of distributable surplus. These IDCW will also be subject to tax.

What are the taxes applicable on capital gains?

The amount and type of tax levied on capital gains will depend on various factors such as your choice of fund, the holding period of the fund, and your income tax slab.
Before we discuss these factors, it’s important to note that as part of The Finance Bill, 2023, the government announced changes to the mutual fund taxation rules, which effectively split mutual funds into three categories from a taxation standpoint.

Below is a table specifying what has changed in the taxation treatment following The Finance Bill, 2023.

Here is how tax on mutual fund is applied for each of the categories described above, as per the new rules.

Tax on equity mutual fund

A mutual fund is considered an Equity-Oriented Mutual Fund if it invests more than 65% of its assets in stocks.
If you invest in an equity fund but sell it within 12 months and make a profit, you will be liable to pay Short-Term Capital Gains (STCG). The STCG levied in this case will be 15% of the profit. You must note that applicable surcharge and cess will also have to be paid, and this tax is irrespective of the income tax slab one belongs to.

However, if you stay invested in the fund for more than a year, any profit at the time of sale will be considered a Long-Term Capital Gain (LTCG). The LTCG tax rate is 10% on gains of over Rs 1 lakh. Also, there is a 15% surcharge that must be paid.
So, if you make a profit of Rs.1.1 lakh in a financial year, you pay LTCG of Rs 1,000 (10% of Rs 10,000, which is the amount exceeding Rs.1 lakh). (For illustrative purpose)

Tax on hybrid mutual fund

If your fund’s equity exposure is less than 65% but above 35%, and you sell the units in under 3 years, your profits will be considered short-term capital gains. In this case, STCG tax will be charged at your income tax rate.
However, if you hold it for more than 3 years, you will pay Long-Term Capital Gains (LTCG) at a tax rate of 20% with an indexation benefit.
Indexation leads to a lower effective tax rate as it adjusts your fund purchase price for inflation. For instance, if you purchased 100 units of a fund at Rs.100 and sold them at Rs.150 after three years. Assuming an inflation rate of 5% in each of those years, your purchase price will be considered Rs.115.76 (Rs 100 compounded at 5% for three years).
So, your tax outgo will be as follows: [(150 - 115.76) x 100 units] = Rs.3,424. Instead of [(150 - 100) x 100 units] = Rs 5,000. (For illustrative purpose only)
The government announces the rate of inflation for every financial year through its ‘cost inflation index’.

The above tax rule was previously applicable for both hybrid mutual funds and debt mutual funds (or all non-equity-oriented mutual funds). However, it now applies only to hybrid mutual funds.

Tax on debt mutual fund

From April 1, 2023, for mutual funds that invest less than 35% in equity (typically debt mutual funds), you will need to pay tax on mutual fund gains at your income tax rate. This means you will not be able to benefit from indexation while calculating long-term capital gains on your debt mutual funds.
There’s one last point you need to know about the recent tax changes. To make sure that the new tax rules come into effect prospectively (or going forward), the government allows the benefit of ‘grandfathering’.
As part of grandfathering, an investor's purchase price in the new system will be considered to be that of the first day of the rule.
The below example will clarify how this works.

Suppose you hold a debt mutual fund unit purchased at Rs.100 on April 1, 2020. As of April 1, 2023, the NAV may have risen to Rs 120. Now if you sell the debt fund unit on March 31, 2024, at a price of Rs 125, you will pay LTCG for the duration of the first three years you held the units (between 2020 and 2023) while for the final year, you will pay tax on the Rs.5 gain as per your income tax slab. (For illustrative purpose only)

What are the taxes applicable on IDCW?

You will need to pay tax on IDCW received from your mutual fund as per your income tax slab. So, if you are in the 30% tax bracket, you will incur the same rate of tax on IDCW that you earn. Mutual fund companies apply 10% Tax Deducted at Source (TDS), so you can adjust this amount when you pay your taxes.

Conclusion:
Mutual fund investments can offer various benefits such as diversification, potential for long term growth, and tax benefits. However, investors need to be aware of the tax implications of mutual fund investments to make informed investment decisions.

An important point to remember is that capital gains tax is not deducted at source unless you are a Non-Resident Indian. This means that if you make a profit, you are required to pay tax when you file your income tax on mutual fund returns.
While we have tried our best to break this topic down simply, if you have any doubt about mutual fund taxation or tax saving strategies, you should consult a chartered accountant or financial advisor for further clarity.

Happy investing!

FAQs:

How are mutual funds taxed?

Profits generated by a mutual fund are typically taxed as short-term capital gains or long-term capital gains. The tax rate can vary depending on the investor’s choice of fund, holding period, and income tax rate.

How should I pay tax on mutual funds?

Mutual fund companies do not typically deduct tax at source. This means that the responsibility falls upon the investors to declare their taxes at the time of filing returns.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.