Nowadays, mutual funds are one of the most popular investment options. They suit all kinds of investors, irrespective of their income. This is due to the benefits they offer, like liquidity and low risk, amongst other advantages. If you are going to invest in them, knowing how they are taxed is very important. You can then make the most of your investment. This article will try to portray the types of tax on mutual funds.
Types of Mutual Funds Taxation
Mutual funds are classified into three types:
- Equity funds
- Debt funds
- Hybrid funds
Each of them is different, and the taxation is also different. Knowing what type of tax and how much you must pay on your returns is important. This gives you a clear idea of your gains from mutual fund investments. These are the various types of taxes:
Capital Gains Tax
The first type of tax on mutual funds is capital gains tax. Capital gain is the amount you earn when you sell your mutual fund assets at a profit. Let’s take an example to make it easier to grasp. Let’s say you buy a few mutual fund units at Rs 500. This is your capital amount. Over time, the investment grows by 10% and is now worth Rs 550. The capital gain is Rs. 50.
- Capital gain = Total income – Capital invested.
The tax applies only to the gain and not the capital. In addition, you only pay the tax when you sell your asset.
Tax on equity mutual funds
If equity investments are sold within a year, the mutual fund returns come under STCG. This stands for short-term capital gains. They are subjected to a 15% tax.
If investments are sold after one year, they are now part of LTCG. This stands for long-term capital gains. The first 1 lakh made is tax-free. However, if your payments exceed Rs 1 lakh, you must pay a 10% tax.
One of the best equity schemes is the ELSS. It stands for “Equity Linked Savings Scheme.” It is a scheme that greatly reduces tax on mutual funds. They have a 3-year lock-in period. You are allowed to claim deductions for your investment in ELSS funds. The amount you can claim is up to Rs. 1.5 lakh.
Tax on Debt Mutual Funds
Mutual fund taxation of debt mutual funds is very different from equity mutual fund taxation.
If you sell debt investments before the end of three years, they will be categorised as STCG. This short-term capital gain is added to your income and taxed accordingly. On the other hand, if it is sold after 3 years, you will be subjected to a tax of 20% with indenture benefits.
The indentation minimises the tax paid. It does so by adjusting capital gains to the Cost Inflation Index. Indexation only applies to non-equity mutual funds. This is one of the advantages of choosing debt mutual funds.
Tax on hybrid mutual funds
A hybrid mutual fund invests in both debt and equity asset classes. They are designed to meet your investment goals better than equity or debt mutual funds. The tax on mutual funds, in this case, varies.
If the hybrid mutual fund allocates more than 65% in equity, equity mutual funds tax rules apply. Otherwise, debt mutual fund taxation applies to it.
Tax on Dividend
If you invest in a mutual fund that pays dividends. You will receive payouts on a timely basis. The profit made by the fund is equally distributed among investors. In this case, the tax on mutual funds is also different. Before 2020, mutual funds had to pay DDT. This stands for Dividend Distribution Tax. Fund houses had to pay around 12% on the base rate.
However, after 2020, this was scrapped by the government. Now, income received as dividends counts as regular income. So, the amount you make from dividends is added to your income. You are then taxed according to the normal tax slabs. This lowers the burden on small investors.
Furthermore, dividends worth more than Rs 5,000 are subject to a 10% TDS. If your PAN is not connected to your Aadhar card, this value becomes 20%.
Factors that determine the tax on mutual funds in India
1. Type of mutual fund
The type of mutual fund you choose affects the amount of income tax you have to pay. As mentioned above, there are two main types: debt and equity mutual funds.
Equity mutual funds invest in equity stocks and shares on the market. They carry high risks due to high market volatility. Also, equity funds are classified as small-cap, mid-cap, and large-cap. This plays a role in the tax on mutual funds you have to pay.
On the other hand, debt funds invest in government bonds, corporate bonds, etc. These are safer options. They offer fixed returns and are low-risk. Debt funds are categorised as short-duration funds, liquidity funds, and income funds.
2. Time Frame of Investment
The amount of time your investment lasts affects the tax on mutual funds you pay. This can be separated into two parts: short-term and long-term investments.
For equity funds, a holding period of fewer than 12 months is categorised as “short-term.” And any investment lasting over a year is considered long-term.
When it comes to debt funds, a holding period of fewer than 3 years is considered short-term. Any tenure of more than three years is considered long-term.
Understanding how mutual fund taxation works is very important. It can take time and seem intimidating at first. But you learn more the more you invest.
For a faster and more in-depth guide on mutual funds and your finances in general, financial advice helps a lot. This is why financial advisors like Piramal Finance are in high demand.