Taxation on equity mutual funds

Equity mutual funds offer investors an excellent way to participate in the growth of the stock market and build long term wealth. However, it is important to understand how capital gains and dividends from such funds are taxed. Proper tax planning can help optimise the return potential from your equity mutual fund investments.

Read on to learn more about equity fund taxation and tips to save tax on equity fund under section 80C of the Income Tax Act, 1961.

• Table of contents

1. What are equity mutual funds?
2. Tax benefits of equity mutual funds
3. Taxation of capital gains from equity funds
4. Effective 80C tax saving tips for equity funds
5. Tax planning for equity funds through SIP
6. How are equity mutual funds taxed?
7. More about mutual fund taxes
8. Short-term capital gains (STCG) tax
9. Equity-Linked Saving Scheme (ELSS)
10. More about mutual fund taxes
11. What are the factors determining tax on equity mutual funds?
12. How returns are generated in equity mutual funds

What are equity mutual funds?

Equity funds invest in stocks or shares of various companies. The fund manager aims to optimize returns by diversifying investments across different sectors and market capitalizations. These funds may offer relatively better returns compared to term deposits or debt-based funds but come with some risk due to market fluctuations.

Tax benefits of equity mutual funds

One of the major tax benefits of investing in equity mutual funds is the deduction available under Section 80C of the Income Tax Act, 1961. For example, Equity Linked Savings Schemes or ELSS funds qualify for tax deductions up to Rs. 1.5 lakh under Section 80C of the Income Tax Act, 1961. ELSS are open-ended equity diversified schemes that invest a minimum of 80% of their total assets in equities. They offer the dual advantage of tax savings as well as participation in equity markets. However, one thing to note is that the overall deduction limit under Section 80C is Rs. 1.5 lakh, including investments made in instruments like PPF, EPF, NSC etc.

Taxation of capital gains from equity funds

Capital gains arising from the sale of mutual fund units are taxed based on whether they are classified as short-term or long-term capital gains.

Short term capital gains (STCG) - If units are sold before completing 12 months from the date of allotment, the gains are termed as short term and taxed at 20% plus applicable surcharge and cess.

Long term capital gains (LTCG) - Units sold after 12 months from the date of allotment attract long term capital gains tax. LTCG up to Rs. 1.25 lakh per financial year is exempt from tax. Above Rs. 1.25 lakh, it is taxed at 12.5% plus applicable surcharge and cess.

Read Also: Understanding Long-Term Capital Gain (LTCG) Tax for Mutual Funds

Effective 80C tax saving tips for equity funds

● Invest in ELSS funds as they qualify for tax deduction up to Rs. 1.5 lakh under section 80C of the Income Tax Act, 1961. Since the mandatory lock-in period is 3 years, all gains from ELSS funds get LTCG benefits.

● Choose growth option to get compounding benefit over longer period. Capital gains attract more beneficial tax treatment compared to Income Distribution cum Capital Withdrawal (IDCW) income.

● Invest lumpsum amount at the start of the financial year for maximum deduction. Balance can be invested via SIP throughout the year under the 80C limit.

Tax planning for equity funds through SIP

Systematic Investment Plans or SIPs are ideal for tax efficient investing in equity mutual funds. Each SIP installment is treated as a separate investment with its own cost of acquisition and indexation benefits. Only the gains arising from the first SIP installment held for more than 12 months will qualify for tax exemption up to Rs. 1.25 lakh under long term capital gains. Profits from other installments sold before completing one year are subject to short term capital gains tax of 20%.

How are equity mutual funds taxed?

While many investors focus majorly on the potential return from their investment, they often tend to overlook the tax consequences when deciding on an investment plan. However, understanding the tax exemptions before investing is always advisable. Equity mutual funds are aimed at encouraging long-term investment and promoting economic growth.

More about mutual fund taxes

The potential gains you make when you sell mutual fund units – that is, the difference between purchase price and sale price – are known as capital gains. Gains on units that were held for more than a year are considered long-term capital gains (LTCG) for taxation purposes. The LTCG tax on equity mutual funds is 12.5% (plus surcharges and cess) on gains exceeding Rs.1.25 lakh in a financial year. However, gains up to Rs. 1.25 lakh are exempt from taxation.

Short-term capital gains (STCG) tax

Short-term capital gains are the gains made on the sale of equity assets held for less than a year. The taxation on these is higher than that on LTCG. Short-term capital gains or STCG are taxed at 20% (plus surcharges and cess), regardless of the investor's income bracket. This aims to discourage frequent trading and promote long-term investment.

For example, if you have a taxable annual income of Rs 7,00,000 and earn Rs 1,00,000 through the sale of equity mutual fund units held for under a year, you will be taxed as per your tax slab on Rs 7,00,000 and will pay a flat rate of 20% (plus surcharges and cess) on Rs 1,00,000.

Equity-Linked Saving Scheme (ELSS)

Equity-Linked Saving Scheme (ELSS) is a category of equity mutual funds that offers tax benefits under Section 80C of the old regime of the Income Tax Act, 1961. ELSS investments of up to Rs 1.5 lakh in a financial year are eligible for deduction from the investor's taxable income.

SIPs allow investors to invest a fixed amount at regular intervals. Each SIP investment is considered a separate investment for the purpose of tax computation.

More about mutual fund taxes

Debt funds

Debt funds primarily invest in fixed-income securities like bonds and treasury bills. Since 2023, capital gains from debt funds are taxed as per the investor’s income tax slab regardless of the holding period.

Dividends

Dividends from mutual funds are taxable in the hands of the investors. The dividend income is added to the investor’s total income and taxed as per their income tax slab rates.

What are the factors determining tax on equity mutual funds?

The tax implications of equity mutual funds are influenced by various elements. Understanding these factors is essential for an investor to thoughtfully manage tax liabilities.

Holding period: The duration for which you hold equity mutual fund units plays a vital role in determining the tax treatment. As mentioned earlier, long-term capital gains are usually subject to a more favourable tax rate compared to short-term capital gains.

Tax rate: The tax rate applied to your gains depends on the prevailing tax laws. It is essential to stay updated with any changes in tax regulations to effectively plan your investments.

Income Distribution cum Capital Withdrawal (IDCW): Some equity mutual funds distribute IDCW to their unit holders. IDCW is taxable as per the applicable tax rates and must be reported in your income tax return

How returns are generated in equity mutual funds

Returns for equity mutual fund investors chiefly stem from two sources: capital gains and dividends.

Capital gains come from the increase in the value of a portfolio’s underlying securities. In other words, if the value of the stocks held by the mutual fund scheme increases, the scheme’s net asset value rises. Investors profit if they sell their mutual fund units at a higher NAV than what they purchased it for.

Dividends, meanwhile, come when companies distribute a portion of their profits to shareholders. These dividends are passed on to the mutual fund that has invested in that company’s stocks.

Conclusion

Systematic Investment Plans or SIPs are ideal for tax efficient investing in equity mutual funds. Each SIP installment is treated as a separate investment with its own cost of acquisition and indexation benefits. Only the gains arising from the first SIP installment held for more than 12 months will qualify for tax exemption up to Rs. 1.25 lakh under long term capital gains. Profits from other installments sold before completing one year are subject to short term capital gains tax of 20%.

FAQs:

Can I claim tax deduction for the entire Rs. 1.5 lakh limit under Section 80C of Income Tax Act, 1961 in equity funds alone?

No, the Rs. 1.5 lakh deduction under Section 80C of Income Tax Act, 1961 is the overall limit that can be claimed by an individual for investing in instruments like PPF, EPF, ELSS funds, NSC etc. combined. Only up to Rs. 1.5 lakh worth of investments made in these qualified instruments together will get tax benefits under Section 80C.

What is an ideal way to invest in ELSS funds to optimize tax savings on equity mutual fund in 80C?

It is ideal to invest the maximum limit of Rs. 1.5 lakh in ELSS funds at the beginning of the financial year itself to get a full tax deduction. Any additional amounts can be invested through SIPs in ELSS or other equity funds over the course of the year. This ensures optimal utilisation of the 80C tax saving limit.

Can I claim deductions for investments made in my spouse's name under Section 80C of the Income tax Act, 1961?

No, tax deductions under Section 80C can only be claimed for investments made individually by self or HUF. Any amount invested by a spouse cannot be claimed as a deduction in the taxpayer's own returns.

How are long-term capital gains from equity funds taxed?

Long-term capital gains from equity funds, i.e., if the investment is held for over one year, are taxed at a rate of 12.5% without indexation benefit.

What is the tax rate on short-term capital gains from equity funds?

Short-term capital gains from equity funds, held for less than a year, are taxed at a rate of 20%.

Are equity oriented mutual funds taxable?

Equity mutual funds taxation holds true under most circumstances. On equity funds held for more than a year, long-term capital gains are taxed at 12.5% plus any applicable cess and surcharges. Equity funds with short-term capital gains that have been held for less than a year are taxed at the applicable income tax slab rate for the individual.

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