Understanding how mutual fund taxes work is crucial for investors. When you sell equity-oriented mutual fund units held for less than one year, the capital gains are deemed short-term and are taxed at your regular income tax rate. However, if you hold the units for more than a year in an equity fund, the gains are considered long-term capital gains and may be subject to special tax treatment. Knowing the ins and outs of mutual fund taxes allows you to better manage your investments, reduce your overall tax burden, and possibly qualify for deductions in certain cases. To make sound investing decisions, mutual funds must stay up to date on ever-changing tax rules.
The tax obligations that arise with investing in mutual funds are referred to as tax on mutual funds. Capital gains from the sale of mutual fund units held for less than three years are generally considered short-term capital gains and are taxed at the investor’s applicable income tax rate. If held for more than three years, the gains are considered long-term capital gains.
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Factors Influencing Mutual Fund Taxation
The taxation of mutual funds is influenced by several significant factors, each of which plays a crucial role in determining the tax implications. The factors include:
Mutual funds are broadly classified into two main types for tax purposes:
Mutual funds may distribute a portion of their profits to investors as dividends, which can be further classified into:
– Dividend Distribution Tax (DDT): This tax is imposed on the mutual fund house for distributing dividends before they are given to investors.
– Income from Dividends: The dividends received by investors are usually taxable in their hands, subject to specific regulations.
The length of time for which an investor holds units of mutual funds significantly affects the tax implications:
– Longer holding periods are generally more tax-efficient, potentially qualifying for preferential tax treatment, such as lower long-term capital gains (LTCG) tax rates and indexation benefits for debt-oriented funds.
– Investors who hold their units for an extended period tend to enjoy reduced tax liabilities, making the holding period a crucial consideration in tax planning.
The taxation of capital gains from mutual funds depends on the holding period:
– Short-Term Capital Gains (STCG): Profits from the sale of units held for less than one year are subject to short-term capital gains tax at the investor’s applicable income tax rate.
– Long-Term Capital Gains (LTCG): Depending on the type of mutual fund, gains from units held for more than one year may receive a lower tax rate or even full tax exemption up to a certain threshold.
Mutual fund investing provides investors with the opportunity to earn returns through capital gains or dividend income. Let’s clarify these concepts and explore their differences in more detail.
Capital Gain refers to the profit obtained from selling an investment, such as a mutual fund or an asset, at a higher price than its original cost. Capital gains are realised only when you redeem mutual fund units. Therefore, the tax obligation for mutual fund capital gains arises solely upon redemption. Investors pay taxes on mutual fund redemptions when they file their income tax returns for the following fiscal year.
Another avenue for mutual fund investors to earn income is through dividends. The mutual fund declares these dividends based on its available distributable surplus. Once disbursed to investors, dividends are subject to immediate taxation at the mutual fund’s discretion. Therefore, investors are liable to pay taxes on dividends received from their mutual funds.
The Finance Act of 2020 introduced an amendment that eliminated the Dividend Distribution Tax (DDT). Previously, until March 31, 2020, dividend income from mutual funds was tax-free for investors. Fund houses that declared dividends deducted a DDT before distributing it to mutual fund investors.
After this change, the entire dividend income is now taxable in the hands of the investor, according to their income tax slab, categorized under the ‘income from other sources.’
Mutual fund schemes are subject to Tax Deducted at Source (TDS) on distributed dividends. Under the revised rules, when a mutual fund distributes dividends to its investors, the Asset Management Company (AMC) must withhold 10% TDS under section 194K if the total dividend paid to an investor surpasses ₹5,000 during a financial year.
When fulfilling their tax obligations, investors can claim credit for the 10% TDS already deducted by the AMC and only settle the remaining balance.
The taxation of capital gains from mutual funds are determined by the type of mutual fund scheme and the duration for which you have held the scheme units.
Firstly, let’s clarify the definitions of Long-Term Capital Gains (LTCG) and Short-Term Capital Gains (STCG). LTCG pertains to the capital gains, which are profits from assets held for an extended period. On the other hand, STCG refers to the capital gains from assets held for a shorter duration.
The tax treatment for equity and debt fund schemes differs in terms of the definitions of long and short durations. For instance, to qualify for long-term capital gains, you must hold your investment for at least 12 months in equity-oriented schemes, while it’s 36 months for debt-oriented schemes.
The table below provides an overview of the required holding periods for capital gains to be considered long-term or short-term:
| Types of Mutual Fund | STCG Holding Period | LTCG Holding Period |
| Equity Funds | Less than 12 months | More than 12 months |
| Debt Funds | Less than 36 months | More than 36 months |
| Hybrid Equity Funds | Less than 12 months | More than 12 months |
| Hybrid Debt Funds | Less than 36 months | More than 36 months |
Taxation on Equity Mutual Funds Capital Gains
Equity funds are mutual funds in which over 65% of the total fund value is invested in equity shares of companies. As previously mentioned, redeeming your mutual fund equity units within one year will result in short-term capital gains, which are taxed at a flat rate of 15%, irrespective of your income tax bracket.
On the other hand, when you sell mutual fund units after holding them for more than one year, you realize long-term capital gains. These gains, up to ₹1 lakh per year, are exempt from tax. However, any long-term capital gains exceeding this limit are subject to a 10% LTCG tax, without the benefit of indexation.
Taxation for debt-oriented mutual funds is relatively simple and offers better tax efficiency compared to conventional investments such as fixed deposits.
Let’s look at the LTCG tax and STCG tax on debt mutual funds separately:
The taxation of capital gains on hybrid or balanced funds hinges on the equity exposure of the portfolio. If the fund’s equity exposure exceeds 65%, it falls under the tax regime applicable to equity funds. Conversely, if the equity exposure is less than 65%, the taxation rules for debt funds come into play. This differentiation is crucial for investors, as it significantly impacts the tax implications when redeeming fund units.
Understanding the equity exposure of the hybrid scheme you’re investing in is essential. Failing to do so may lead to unexpected tax outcomes when you decide to redeem your fund units. To ensure you’re well-informed about the tax implications of your investment, it’s advisable to review the fund’s equity exposure and consult with a financial advisor if needed.
Below is a summarized table of the taxation rates on capital gains from mutual funds:
| Types of Fund | Short-Term Capital Gains | Long-Term Capital Gains |
| Equity Funds | 15% + cess & surcharge | Gains above Rs. 1 lakh taxed at 10% + cess + surcharge |
| Debt Funds | According to the investor’s income tax slab rate | According to the investor’s income tax slab rate |
| Hybrid Equity – Oriented Funds | 15% + cess & surcharge | Gains above Rs. 1 lakh taxed at 10% + cess + surcharge |
| Hybrid Debt- Oriented Funds | According to the investor’s income tax slab rate | According to the investor’s income tax slab rate |
Taxation on Capital Gains When Investing in SIPs
Systematic Investment Plans (SIPs) allow investors to periodically invest small amounts in mutual fund schemes, offering flexibility in choosing the investment frequency, such as weekly, monthly, quarterly, bi-annually, or annually.
With each SIP installment, you acquire a specific number of mutual fund units, and upon redemption, the units are liquidated on a first-in-first-out basis. For instance, if you invest in an equity fund through SIPs for one year and redeem your entire investment after 13 months, the units purchased initially through SIPs qualify as long-term holdings (over one year). Any long-term capital gains on these units under Rs. 1 lakh are tax-free.
On the other hand, units purchased through SIPs from the second month onward are considered short-term holdings, resulting in short-term capital gains. These gains are taxed at a fixed rate of 15%, irrespective of your income tax bracket, with applicable cess and surcharge added to the tax amount.
Section 80C Deductions under ELSS
The Equity Linked Savings Scheme (ELSS) is one of the most important tax-saving instruments under Section 80C of the Income Tax Act. These mutual funds generally invest in equities and equity-related securities, which provide both wealth building and tax benefits. Investments in ELSS can be deducted up to Rs. 1.5 lakh annually under Section 80C of the Income Tax Act. This minimises the investor’s taxable income, resulting in significant tax savings.
When you have made capital gains or losses in a financial year, it is important to report them by filing either ITR Form 2 or 3 (if you are ineligible for ITR 2). Capital gains from mutual funds are taxed when units are redeemed. Individuals earning capital gains must file ITR 2, while those earning from business or profession must file ITR 3.
Capital gains refer to the difference between the purchase and sale prices of mutual fund units. If the sale price exceeds the purchase price, it is considered a gain; if it is lower, it is a loss. The Income Tax Act allows for adjusting losses with profits, with long-term losses against long-term gains, and short-term losses against both types.
To report capital gains in ITR, follow these steps:
1. Log in to the Income Tax Department’s website.
2. Choose ‘e-file’ > ‘Income Tax Returns’ > ‘File Income Tax Returns’.
3. Select the assessment year, status, and form type.
4. Choose ‘taxable income is more than exemption limit’ as the reason.
5. Select ‘General’ > ‘Income Schedule’ > ‘Schedule Capital Gains’ and asset type.
6. For short-term gains, add the total sale amount and Cost of Acquisition.
7. For long-term gains, provide scrip-wise details in ‘Schedule 112A’.
8. Confirm schedules, preview the return, download ITR, and make the declaration.
9. Provide specific details, validate, file ITR, and e-verify electronically.
10. Processing usually completes within 120 days after filing.
Taxes in mutual fund schemes are usually incurred upon unit redemption or sale, not yearly. Yet, dividends received in the current fiscal year are part of your total income and may be taxed if your overall income is taxable.
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