Mutual funds are also taxed like other investments by the government. The SEBI (Securities and Exchange Board of India) lays down the rules for taxation. However, the tax rules differ for equity and debt funds as well as for dividends and capital gains. Some funds like hybrid funds or dynamic asset allocation funds are also taxed either as equity or debt as per their asset allocation and SEBI norms. The rules for long-term and short-term investments also differ, for both equity and debt funds. Some funds also offer tax benefits.
Let’s discuss in detail the taxation and tax exemption of mutual funds.
Taxation Rules for Mutual Funds
Before we discuss the taxation rules for mutual funds, it is important to know about the dividend plan and the growth plan. Mutual funds, being subject to market risks, undergo various cycles and may show appreciation and depreciation in the unit value on a daily basis. However, the funds lead to capital appreciation in the long run. During short intervals, when the funds perform well, the surplus cash earned from the returns of the fund may be distributed among the investors. This is known as a dividend that is proportional to the units of a mutual fund scheme held by investors.
When the scheme ends and units are redeemed, the total fund value including the invested value and the returns on it count for the capital gains of the investor. Therefore, mutual funds are categorized into two types where investors take the regular dividend payouts in the dividend plan. Whereas, in the growth plan, the dividends are reinvested.
1. Tax on Dividend Plans
Earlier there was no tax on dividend plans because the fund houses paid a Dividend Distribution Tax (DDT) to the government. This was deducted before declaring the dividends. Now from April 2020 onwards, there is a change in the rule where TDS (Tax Deducted at Source) is imposed and DDT is abolished. Now the dividends received in a year are tax-exempt up to Rs. 10 Lakh and above this limit, 10% of the total earnings is taken as tax.
2. Tax on Capital Gains
Capital gained from mutual funds is taxed at varying rates in the case of long-term capital gains and that short-term capital gains. It is also different for equity and debt and even the duration for long-term and short-term gains differ for both bonds. They are:
In the case of equity funds, long-term gains are tax-free up to Rs. 1 Lakh and taxed at 10% above this limit. The long-term gains for debt funds are taxed at a flat rate of 20% with indexation benefits. Indexation is the adjustment in the purchase price of an investment to reflect the inflation impact. With indexation benefits, investors can lower the long-term capital gains to show lesser tax liabilities.
Short-term capital gains (STCG) for equity funds are taxed at 15% whereas, in the case of debt funds, the returns are added to the taxable income. Therefore, debt funds will be taxed as per the tax slab in which the investors fall into, after adding the capital gains to their income.
5. Tax Benefits
Not all mutual funds carry tax benefits, except for ELSS (Equity Linked Savings Scheme) and ULIP (Unit Linked Savings Scheme). Both ELSS and ULIP are tax-exempt up to Rs. 1.5 Lakh under Section 80C like other tax-efficient investments under this section. Section 80C allows a total exemption up to Rs. 1,50,000 in a financial year taking into account all investments under this section like PPF, NSC, etc.
As the name indicates, ELSS is equity and a special type of tax-saver fund. ULIP, on the other hand, is an insurance product with the benefits of mutual funds. ULIP can be equity, debt, or hybrid depending upon the asset allocation and can be taxed like one. However, it also has exemption up to the prescribed limit in a year under Section 80C of the Income Tax.
6. Securities Transaction Tax
The Ministry of Finance levies 0.001% tax as Securities Transaction Tax (STT) in case of certain funds. They levy this tax when the investors decide to buy or sell units of equity or equity-oriented fund. This is not applicable in the case of debt funds.
Tenure for LTCG and STCG
Reiterating the fact that it is the duration for which mutual fund units are held, that determines the gains will be considered long-term or short-term. In the case of equity funds, if units are redeemed within a year, they are considered short-term gains. Any redemption after 1 year is long-term capital gains. This tenure is expanded to 3 years for debt funds, that is short-term gains if redeemed in less than three years. If debt funds are redeemed after 3 years, they are taxed like long-term capital gains. Here is a table that will help to understand better:
|Type of Funds||Tenure for LTCG||Tax on LTCG||Tenure for STCG||Tax on STCG|
|Equity Funds||More than 1-year||10%||More than 1-year||15%|
|Equity-oriented Hybrid Funds||More than 1-year||10%||More than 1-year||15%|
|Debt Funds||More than 3 years||20% with Indexation||More than 3 years||Added to Income Slab|
|Debt-oriented Hybrid Funds||More than 3 years||20% with Indexation||More than 3 years||Added to Income Slab|
Wrapping it Up
Investors who worry if their returns from mutual funds will be minimized after paying taxes can know how mutual funds are taxed. Knowing the norms of taxation that differ for long-term and short-term investments in equity and debt funds, they can calculate what is beneficial for them. They can also save taxes other than corpus generation by investing in tax-saver funds. Taxation remains the same for a type of fund whether invested in a lump sum or through a SIP (Systematic Investment Plan). Investing for the long term can be more tax-efficient than holding the units for a short-term duration.