Tips for tax-efficient mutual fund investing

Mutual funds provide an efficient way for investors to build wealth over the long run. By pooling money from multiple investors and investing in a diversified portfolio, mutual funds allow even small investors to access a wide variety of asset classes. However, it is important for investors to understand the tax implications of investing in mutual funds and employ tax-efficient mutual fund investment strategies to optimize the return potential.

This article provides an overview of tax rules for mutual funds and shares practical tips for tax-efficient mutual fund investing.

• Table of contents

1. Understanding tax implications of mutual fund investing
2. Taxation of IDCW (Income Distribution cum Capital Withdrawal)
3. Taxation of capital gains from equity funds
4. Taxation of capital gains from debt funds
5. Strategies for tax-efficient mutual fund investing
6. How to avoid long term capital gain tax (LTCG) on mutual funds?

Understanding tax implications of mutual fund investing

Mutual funds investments are required to pay tax on their income and capital gains every year. There are two main types of taxes investors should be aware of – taxes on dividend income and taxes on capital gains. Additionally, the taxation on capital gains also depends on the type of mutual fund (equity or debt) and the holding period for the units.

Taxation of IDCW (Income Distribution cum Capital Withdrawal)

IDCW from mutual funds are taxable in the hands of the unit holders. The IDCW income is clubbed with the total income of the investor and taxed as per their income tax slab rates. Additionally, the mutual fund company is required to deduct a 10% TDS if the dividend pay-out exceeds Rs. 5,000 in a financial year. However, unit holders can claim tax rebates for the TDS amount paid by the mutual fund company while filing their income tax returns.

Taxation of capital gains from equity funds

Capital gains arising from the sale of equity or equity-oriented 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 held for less than 12 months, the gains are classified as STCG and taxed at 15%.
• Long Term Capital Gains (LTCG) – If units are held for more than 12 months the gains are classified as LTCG. These gains are exempted from taxation up to Rs. 1 lakh per financial year. LTCG above Rs. 1 lakh are taxed at 10% plus applicable surcharge and cess.

Taxation of capital gains from equity funds

Units purchased after April 1 ,2023– Capital gains arising from sale of debt fund units purchased after April 1, 2023, no longer receive indexation benefit and are considered to be short-term capital gains irrespective of the holding period. Therefore, they are added to the investor’s taxable income and taxed at the applicable slab rate.

Units purchased before April 1 ,2023– Gains from debt fund investments made before April 1, 2023 – and held for a period of 36 months or more – are considered long-term capital gains and taxed at 20% with indexation benefit.

Strategies for tax-efficient mutual fund investing

Understanding these tax rules allows investors to adopt strategies to reduce their tax outgo and optimise the post-tax return potential from mutual funds. Some of the main strategies include the below.

• Investing through ELSS funds to avail tax benefits under Section 80C of the Income Tax Act, 1961. Up to Rs. 1.5 lakh invested provides tax deduction.
• Holding equity funds for more than one year to qualify for long term capital gains tax of 10%.
• Switching to growth options of funds and reinvesting dividends to buy additional units.
• Harvesting tax losses using the concept of cost averaging by redeeming loss-making units and purchasing profit-booking units.

How to avoid long term capital gain tax (LTCG) on mutual funds?

You can avoid paying tax or minimise your tax burden by planning annual withdrawals in such a way that the capital gains are under or close to exemption limit of Rs. 1.25 lakh.

Conclusion

By understanding tax rules and proactively managing their mutual fund portfolio for taxes, investors can enhance post-tax returns significantly. Using techniques such as the ones outlined here, investors can minimise the tax outgo on gains and dividends from mutual funds. Tax-efficient investing through mutual funds thus provides an effective vehicle for potentially accumulating wealth over the long run. Investing in mutual funds through SIP offers the advantage of rupee-cost averaging. A one time SIP calculator is a useful tool to estimate the potential returns from SIPs.

FAQs

Are there any relative disadvantages to investing in tax-efficient mutual funds?

Tax-efficient funds, through their focus on limiting transactions, try to defer capital gains distributions to benefit investors from a tax perspective. The trade-off is they sometimes pursue slightly lower pre-tax returns than more actively traded tax-inefficient funds.

Are there any tax implications if I sell my mutual fund shares at a loss?

Selling mutual fund shares at a loss can provide tax benefits. Any capital losses from the sale can be used to offset capital gains from other investments sold at a profit in the same tax year. This allows the losses to directly reduce the amount of gains included in taxable income on a rupee-for-rupee basis.

Can I offset capital gains from mutual funds with capital losses from other investments?

Individual taxpayers are allowed to offset capital gains arising from mutual fund investments against capital losses from other assets. As per the Indian taxation system, capital gains and losses are first netted within the same asset class. So, any losses from the sale of certain mutual funds can offset gains made from other mutual funds during the financial year.

Is there any exemption on LTCG on mutual funds

LTCG of up to Rs. 1.25 lakh in equity-oriented mutual funds are tax exempt.

What changes have been made to the LTCG exemption limit?

The Union Budget 2024 introduced significant changes to the taxation of long-term capital gains (LTCG) on equity-oriented mutual funds. Prior to this amendment, long-term capital gains from equity investments were taxed at 10%. Gains of up to Rs 1 lakh in a financial year were tax-exempt. However, under the new tax regime, LTCG is taxed at 12.5%, with an exemption on gains of up to Rs. 1.25 lakh a financial year.

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 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.