taxation in mutual funds

Consumers invest in mutual funds to build their wealth. As an investor, you need to know that there is something known as “capital gains”, also called as taxation in mutual funds, which are taxed by the income tax authorities.

Capital Gains refers to an increase in the value of an investment over a specific time frame. If the Nest Asset Value (NAV) of your debt fund was Rs 10 last year and today it stands at Rs 15, your investment has experienced a capital gain. This tax is incumbent upon the time for which you stay invested in them, known as Holding Period, which can be both short term and long term.

In case of equity mutual funds and hybrid mutual funds, a holding period of 12 months or more is regarded as long-term. In case of debt mutual funds, a holding period of 36 months or more is regarded as long-term. A holding period of less than 36 months for debt funds and less than 12 months for equity and balanced funds is defined as short-term.

Let’s have a look at the taxation in mutual funds as it applies to different fund categories.

Tax-Saving Equity Funds

Equity-Linked Saving Schemes (ELSS) are efficient tax-saving instruments under Section 80C of the Income Tax Act, 1961. These are essentially diversified equity funds which invest in equity shares of companies across market capitalization. These come with a lock-in period of 3 years, upon the completion of which, capital gains (Long term) up to Rs 1 lakh are tax-free in your hands. Anything over and above it is taxed at the rate of 10%. You can invest in ELSS through Sqrrl’s curated top performing Axe tax product.

Equity Funds

Long-term capital gains on regular equity funds of up to Rs 1 lakh are tax-free in your hands. Short-term Capital gains from equity funds, if the units are redeemed before 12 months, are taxed at the rate of 15% on the Capital gain.

Debt Funds

Long-term capital gains on debt fund are taxed at the rate of 20% after indexation. (Indexation is a method of factoring in the rise in inflation between the year when the debt fund units were bought and the year when they are sold)

Let’s say you invested in a debt fund in April 2015. Your investment amount was ₹10,000 and you bought the units at a NAV of ₹10, the accrued number of units (10000/10=1000 units). Three years later, in May 2018, you redeemed your 1000 units at let’s say NAV of ₹20. When you sell your investments, the value you get is ₹20,000 (1000 units x 20 NAV).

Thus, your investment made capital gains worth ₹10,000 ( 20000-10000). The indexation benefit means that you will not pay tax on this entire amount of ₹10,000. As your holding period was 3 years, you will get the benefit of indexation to reduce the value of your long-term capital gains.

However, there is a bit of calculation involved. The Indexation formula is,

Original cost of acquisition x (CII of year of sale/CII of year of purchase), where CII stands for cost inflation index. 

Hence, instead of ₹10,000, your capital gains will now be taxed on (₹20,000 – Indexation formula result) – a lower amount.

Short term capital gains on the other hand are added to income and taxed at existing income tax slab rates.

Balanced Funds

Balanced funds are equity-oriented hybrid funds that invest at least 65% of their assets in equities. Their tax treatment is exactly the same as non-tax saving equity funds.

Dividend Mutual Funds

A dividend mutual fund primarily invests in companies that pay dividends. Even though most dividend mutual funds strive to pay dividends, it is never guaranteed. An investor should note that under this option, the NAV usually gets capped. As soon as the NAV reaches a specific level, the fund house pays out the dividends. Dividends are tax-free in the hands of the investor.

However, fund house pays a dividend distribution tax 28.84% for debt funds while it is zero for equity funds.

Consumers can opt for growth or dividend mutual funds based on their investment goals, but before you do so, it’s extremely important to understand the taxation in mutual funds. Growth option is better than dividend as compounding effect is lost when fund houses pay you dividends.

Sqrrl recommends direct mutual funds with growth options, to maximize your savings and help you realise your goals.




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