Mutual Fund Taxation

Mutual Fund Taxation

The main aim behind investing in mutual funds is to earn capital gains. But you need to know that these capital gains are taxed by the income tax authorities. The amount of tax to be paid on capital gains depends on the time for which you stay invested in them(holding period), kind of funds you are investing (equity or debt) and capital gain.(More or less than 1 lac)

What is a Capital Gain?
Capital gain is a profit or gain that arise from our investment. If you buy something for Rs 2 Lakh & sell it for Rs 2.5 Lakh, you have made a Capital Gain of Rs 50000. Capital Gains are further divided into short term & long term depending on their investment horizon.

Long Term Capital Gain
If you make a gain/profit on your investment in a Equity Mutual Fund scheme that you have held for over 1 year, it will be classified as Long Term Capital Gain. If you make a gain/profit on your investment in a Non-Equity Mutual Fund scheme (Debt Fund) that you have held for over 3 years, it will be classified as Long Term Capital Gain.

Short Term Capital Gain?
If your holding in a Equity mutual fund scheme is less than 1 year i.e. if you withdraw your mutual fund units before 1 year, after making a profit, then the profit will be considered as Short Term Capital Gain. If you make a gain/profit on your Debt fund (or other than equity oriented schemes) that you have held for less than 36 months (3 years), it will be treated as Short Term Capital Gain.

Holding period : The holding period of mutual fund units can be short-term or long-term. In case of equity mutual funds and balanced mutual funds, a holding period of 12 months or more is regarded as long-term (As discussed above) and less than 12 months is defined as short-term. In case of debt mutual funds, a holding period of 36 months or more is regarded as long-term and less than 12 months is defined as short-term.

Now let’s have a look at the taxation of short-term gains and long-term capital gains on different types of mutual funds.
Equity Schemes-
If you sell your equity investments before a year, returns would be treated as short-term capital gains and taxed at 15%. If you sell your equity investments after a year, returns would be treated as long-term capital gains. LTCG of up to Rs 1 lakh are tax-free in your hands. LTCG in excess of Rs 1 lakh is taxed at the rate of 10% without the benefit of indexation. Exm- If you invest Rs 1 lakh in XYZ Fund & after 1 year, its value is Rs 1.3 Lakh – there will be zero tax on capital appreciation of Rs 30000.

Debt Schemes-
If you hold your debt investments for less than three years, returns are treated as short-term capital gains for taxation purpose. Short-term capital gains are added to the income and taxed according to the income tax slab applicable to the individual. If you hold your debt investments for more than three years, returns would be considered as long-term capital gains and taxed at 20% with indexation benefit.

Balance Schemes-
Balanced funds are equity-oriented hybrid funds that invest more than 65% of their assets in equities. This is why their tax treatment is exactly the same as equity funds.

ELSS Schemes-
ELSS comes up with a lock-in period of 3 years. It means that once you invest in ELSS, you cannot redeem your units before expiration of 3 years. Investments in ELSS is qualify for tax deductions of up to Rs 1.5 lakh under Section 80C of the Income Tax Act. However, after the re-introduction of LTCG tax in the budget 2018, returns from them would be taxed. Long term capital gains from equity mutual funds abover Rs 1 lakh would be taxed at 10 per cent without any indexation benefit.

Important-
An SIP or a systematic investment plan is the method of investing a fixed amount in a mutual fund in a periodic manner. Gains made from SIPs are taxed as per the type of mutual fund and the holding period. For the purpose of taxation, each individual SIP is treated as a fresh investment and gains on it are taxed separately.
Suppose you begin an SIP of 1,000 a month in an equity fund for 12 months. Each individual SIP is considered to be a fresh investment. Hence, after 12 months, if you decide to redeem your entire amount (investments plus gains), all your gains will not be tax-free. Only the gains earned on the first SIP would be tax-free because only that investment would have completed one year. The rest of the gains would be subject to short-term capital gains tax.(15 % tax)
Apart from these, there is also something called the Securities Transaction Tax (STT). An STT of 0.001% is levied by the fund company itself when you sell units of an equity fund or balanced fund. There is no STT on the sale of debt fund units.

Mutual Funds Taxation Rules on Dividends

Dividends on Equity Mutual Funds:
The dividend received in the hands of unit holder for an equity mutual fund is completely tax free. The dividend is also tax free to the mutual fund house.

Dividends on Debt Funds:
The dividend income received by a debt fund unit holder is also tax free. But, the mutual fund company has to pay a dividend distribution tax (DDT) before distributing this dividend income to its Unit-holders. DDT on Debt Mutual Funds is 28.84%.