Chapter 12: How are Mutual Funds Taxed?
Navigating the world of mutual fund investments can be complex, and understanding their tax implications is crucial for both novice and experienced investors. This chapter demystifies the taxation of mutual funds in India, providing you with the essential knowledge to make informed investment decisions and optimize your returns.
Mutual fund taxation in India is multifaceted, varying based on factors such as the type of fund, holding period, and the investor’s tax bracket. Whether you’re considering your first mutual fund investment or looking to refine your existing portfolio, grasping these tax nuances can significantly impact your overall financial strategy.
In the following sections, we’ll explore the different categories of mutual funds from a tax perspective, delve into capital gains taxation for various fund types, and uncover the benefits of indexation. We’ll also discuss dividend taxation, securities transaction tax, and special considerations for famous tax-saving schemes like ELSS.
By the end of this chapter, you’ll have a comprehensive understanding of how mutual funds are taxed, enabling you to align your investment choices with your financial goals while keeping tax efficiency in mind.
We’ll also share tax-efficient strategies that can help you maximize your after-tax returns. The examples shared here are by no means to be considered any financial or tax advice and are solely for education. Do ensure you consult your financial and tax advisors who can help you with the subject.
Remember, while tax considerations are important, they should be balanced with other factors such as risk tolerance, investment objectives, and overall portfolio strategy.
This chapter will explain the key aspects of mutual fund taxation in India for the financial year 2024-25, catering to both beginners and experienced investors.
Let’s dive in and demystify mutual fund taxation!
Taxation Explained
Taxation Categories
Mutual fund taxation in India is primarily determined by the fund’s asset allocation. The three main categories for tax purposes are:
- Equity Funds: Funds with 65% or more investment in equity and equity-related instruments.
Examples: Most equity-oriented schemes, including large-cap, mid-cap, small-cap funds
Special inclusion: Arbitrage funds, despite their lower risk profile - Debt Funds: Funds with less than 35% investment in equity.
Examples: Gilt funds, corporate bond funds, liquid funds, ultra-short duration funds - Hybrid Funds:
These are further divided into three sub-categories:
Capital Gains Taxation
- Equity Funds:
- Debt Fund:
- Hybrid Funds:
As discussed in point 1 c) (you can refer to this )
**Indexation Benefit Explained
Indexation adjusts the purchase price for inflation, reducing the taxable gain. Applicable to debt funds and hybrid funds with 35-65% equity exposure when held for more than 36 months.
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- Dividends are taxable in the hands of investors at their applicable income tax slab rates
- TDS of 10% is applicable on dividend payments exceeding ₹5,000 in a financial year
Securities Transaction Tax (STT)
- Applicable on the sale of equity-oriented mutual fund units: 0.001% (payable by the seller)
- Not applicable on the purchase of mutual fund units or sale of debt fund units
Special Considerations in Taxation
a) ELSS (Equity-Linked Savings Scheme)
– Qualifies for tax deduction up to ₹1.5 lakh under Section 80C
– Subject to a lock-in period of 3 years
– Taxed like other equity funds after the lock-in period
b) International Funds
– Treated as debt funds for taxation purposes, regardless of underlying assets
Tax-Efficient Strategies
Mutual fund investing is subject to taxation as we discussed and that’s the reason being aware of how taxation applies to your investments in mutual funds can give you creative ways to minimize your tax liability and you can maximize your returns.
After all, money saved is money earned, isn’t it? And therefore if you understand how taxation is applicable, you can make informed decisions and save taxes smartly. Here are some ways explained for education purposes only:
a) Long-term investing: Holding debt funds for more than 3 years can significantly reduce tax liability due to indexation benefits.
b) LTCG harvesting: As we have learned the taxation laws exempt us from tax on capital gains up to 1 lakh rupees every financial year in equity funds. You may consider booking gains up to ₹1 lakh annually to utilize the tax-free limit. One problem year could be exit loads being applicable and thus you need to ensure that if you try this method, the LTCG harvesting is a profitable option or not.
Again these are some of the ways you can consider but after a thorough evaluation and consultation from a tax expert or conducting your research before you come to any conclusion.
The point of explaining this is to highlight that if you can track your mutual funds systematically, you can try and maximize your gains and minimize your losses.
Some other important notes for investors:
- Tax laws are subject to change; stay updated with the latest regulations. While tax efficiency is important, it shouldn’t be the sole factor in investment decisions.
- Consider your investment goals, risk tolerance, and overall portfolio strategy when selecting mutual funds.
- For complex tax situations or large investments, consult a tax professional or financial advisor
Taxation as per Investing Style
So now that we have simplified the taxation laws for you. Further, let’s take some practical examples of 3 most common ways investors choose to invest in mutual funds and let’s see how taxation works in the following cases:
- Lump Sum Investing.
- SIPs
- SWPs
Let’s use an equity mutual fund for our examples, as it’s a common choice for many investors.
Scenario 1: Lump Sum Investing
Mr. Sachin has a lump sum of money to invest and he chooses to invest the entire money in an equity-oriented mutual fund
Let’s say he invests a lump sum of ₹100,000 on April 1, 2024.
On March 31, 2026 (after 2 years), his investment value grew to ₹130,000.
So how would the Tax Calculation work here for Mr Sachin:
– Holding period: More than 1 year, so it’s Long Term Capital Gain (LTCG)
– Capital Gain: ₹130,000 – ₹100,000 = ₹30,000.
But wait, what did we discuss, capital gains > 1 lakh is tax-free. Therefore,
– Taxable amount: ₹30,000 – ₹1,00,000 (LTCG exemption) = ₹0
– Tax payable: ₹0 (as the gain is within the ₹1 lakh annual exemption limit)
Mr. Sachin is not liable for any tax gains!
Scenario 2: SIP - Systematic Investment Plan
Let’s say Mr Rohit invests ₹10,000 monthly for 24 months starting April 1, 2024.
Total investment: ₹240,000
On March 31, 2026, his investment value reached ₹280,000.
Tax Calculation:
– Each SIP installment is considered a separate investment
– Some units will be held for more than 1 year (LTCG), others for less (STCG)
– Let’s assume ₹200,000 worth of “units “qualify for LTCG and ₹80,000 for STCG
Scenario 3: SWP - Systematic Withdrawal Plan
Let’s say Mr Mahi invested ₹500,000 lump sum on April 1, 2024, and started a monthly systematic withdrawal of ₹10,000 from April 1, 2025.
By March 31, 2026, you’ve withdrawn ₹120,000 (12 x ₹10,000).
Assuming the fund value on March 31, 2026, is ₹450,000.
Tax Calculation:
Key Points to Remember
- In lump sum investing, the entire investment is considered as a single transaction for tax purposes.
- For SIPs, each installment is treated as a separate investment, potentially resulting in a mix of STCG and LTCG.
- In SWPs, each withdrawal may consist of both your principal and gains. The gain component is subject to taxation.
- For equity funds, LTCG up to ₹1 lakh per financial year is tax-free. Gains above this are taxed at 10% without indexation.
- STCG on equity funds is taxed at 15%.
- For debt funds, the taxation would be different, with STCG taxed at slab rates and LTCG taxed at 20% with indexation benefits.
These examples demonstrate how the mode of investment and withdrawal can impact your tax liability. It’s always advisable to consult with a tax professional for personalized advice based on your specific financial situation.
Conclusion
Understanding mutual fund taxation is essential for optimizing your investment returns. By considering the tax implications of different fund categories and holding periods, you can make more informed decisions about your mutual fund investments.
Remember that while tax efficiency is important, it should be balanced with other factors such as risk, returns, and alignment with your financial goals.
With this we come to an end on this chapter. In the next chapter, we shall discuss whether mutual funds are safe for investing. What are the risks involved in mutual fund investing