Tax on Mutual Funds: How mutual funds returns are taxed?

Introduction

Mutual fund returns are taxable, as are the returns of most other asset classes in India. Generally, mutual fund returns are taxed based on the type of mutual fund scheme you’re invested in and the period you’ve held your investment before selling it. These two basic rules are foundational in understanding taxation on mutual funds.

No taxes are levied during the holding period for mutual fund investments as they are unrealised gains. Mutual fund returns are only taxed when you sell your allocations or receive dividends from your investment. So, let’s review the complete details of how various types of mutual funds are taxed and what dividend income taxes are.

Understand what is Taxation on Mutual Funds

When you either receive dividends from your mutual fund investments or sell your allocations, you have to pay taxes to the government. The taxes on mutual fund returns are calculated and levied following the Income Tax Act of 1961. There are three taxes commonly associated with mutual fund returns: short-term capital gains tax (STCG), long-term capital gains tax (LTCG), and income tax on dividends. Knowing how these taxes affect your mutual fund returns can help you plan tax-saving measures to maximise your returns accordingly

Key Factors Influencing Mutual Fund Taxation

Four main factors influence how much tax investors have to pay on mutual funds. Once mutual fund taxation is broken down into these four subsections, it becomes much easier to understand.

1. Fund Type

Mutual funds can be categorised broadly into equity-oriented or debt-oriented funds to understand mutual fund taxation easily.

2. Investment Duration

How long your funds remain invested helps determine your capital gains liability. Indian taxation policies encourage long-term investment holding, which is why longer investment durations attract lower taxes.

3. Capital Gains

When you sell your mutual fund units at a higher price than you purchased, that counts as capital gains. This information is necessary when calculating the taxes on your mutual fund investments.

4. Dividends

Dividends are a share of the profits accumulated by the mutual fund house distributed among investors. If the dividends are paid out to investors directly, they attract taxes.

What are the Types of Funds

The two broad categories of mutual funds necessary for taxation are equity-oriented and debt-oriented. Let’s review how a mutual fund is classified into these categories.

1. Equity-Oriented Fund

The fund’s asset allocations determine an equity-oriented mutual fund. As per the SEBI mutual fund regulations, any fund that has invested over 65% of the scheme’s assets into equities and related instruments is considered an equity-oriented mutual fund.

2. Debt-Oriented Fund

Debt-oriented funds invest in fixed-income instruments like government and corporate bonds. These funds have lower risk profiles than equity funds but offer lower returns.

There are other hybrid funds, but their taxation is determined by first classifying them as equity-oriented or debt-oriented mutual funds.

How Profits are Generated in Mutual Funds

Mutual funds generate profits in two main ways: capital gains and dividends. Let’s understand how each of these profits works to understand their taxation better.

1. Capital Gains

When you purchase a mutual fund unit at an NAV (Net Asset Value) of ₹150 and hold your investment, it is considered capital gains whenever the unit's value goes above ₹150. The taxes on these capital gains are only levied when you sell your mutual fund units. The investor is responsible for accurately reporting their capital gains and paying necessary taxes at the time of their income tax returns in the appropriate financial year.

2. Dividends

Dividends are paid out by the mutual fund houses as a part of profit distribution among investors. The dividends are technically income for investors, and as such, income taxes are levied on this type of profit. The income tax rate of the dividends earned is calculated per the investor's income tax slab. (If the investor is on an income tax slab of 20%, the dividend returns will also be taxed at the same). Also, if the annual dividend payout crosses the mark of ₹5,000 from any mutual fund investment, the mutual fund house must deduct a TDS of 10% before paying out the dividends.

Taxation of Dividends Provided by Mutual Funds

The rules regarding the taxation of dividends provided by mutual funds have recently changed. Before March 31, 2020, mutual fund houses only deducted a small Dividend Distribution Tax before paying dividends to investors. After the introduction of the Finance Act 2020, dividend returns are now taxed in the hands of the investors at their respective income tax slabs under the heading “income from other sources”.

TDS is also deducted at 10% on dividend payments over ₹5,000 annually by mutual fund houses before dividend payouts to investors. The deducted TDS can be claimed in income tax returns to lower the tax liabilities on dividend returns.

Taxation of Capital Gains Provided by Mutual Funds

When investors try to calculate how much tax on mutual funds they have to pay, this is one of the most important taxes to consider. Capital gains tax is levied as either STCG or LTCG on mutual fund holdings. The two factors that help determine the tax rate are the type of fund you’re invested in and the holding period. Here’s a tabulated view of mutual fund types and taxes they attract based on their holding period.

Taxation on Equity Funds

Mutual fund equity taxation is imposed based on the holding period. Short-term or long-term capital gains taxes are levied on equity-oriented mutual fund returns. Here’s a detailed look at how equity-oriented mutual funds attract capital gains taxes.

1. Equity-oriented fund returns are taxed during redemption at 15% flat for STCG.

2. LTCG is levied at 10% without indexation benefits beyond the exemption limit of ₹1 lakh.

Cess and surcharge taxes may also be levied on both short-term and long-term capital gains taxes for equity-oriented funds.

A securities transaction tax (STT) is also debited on the purchase and sale of equity-oriented mutual fund units at 0.001% of the transaction amount.

Taxation on Debt Funds

After the Union Budget 2023, the indexation benefits of debt funds were removed. Any short-term or long-term capital gains you generate from debt funds are taxed per your current income tax slab without indexation benefits.

Taxation on Hybrid Funds

Hybrid funds are taxed as per their orientation. Here’s a detailed look at how hybrid mutual funds are taxed.

1. Equity-Oriented Hybrid Funds

STCG of 15% is levied along with cess and surcharge (if applicable). LTCG is imposed on gains at 10% beyond the exemption limit of ₹1 lakh per year.

2. Debt-Oriented Hybrid Funds

Like other debt funds, hybrid debt-oriented funds are also taxed according to the investor’s existing income tax slab without income tax benefits.