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Understanding Mutual Fund Taxation: A Comprehensive Guide

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  • Post published:October 29, 2023
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Last Updated on October 29, 2023 by Sumitha

How Mutual Funds Are Taxed?

Mutual funds have become popular for investors seeking to achieve their financial goals while enjoying tax-efficient returns. In contrast, traditional fixed deposits, especially for individuals in the highest income tax bracket, can lead to significant disadvantages due to the taxation of interest income at their applicable income tax slab rate. This is where mutual funds emerge as the more tax-efficient option, providing expert money management and the advantage of tax-efficient returns.

The Latest Update – Budget 2023

As of the latest budget update in 2023, there have been some notable changes in the taxation of mutual funds. Indexation benefits will no longer be available for calculating long-term capital gains on specified mutual funds, which invest less than 35% of their proceeds in the equity shares of domestic companies. Additionally, debt mutual funds will be taxed according to the applicable slab rates.

Understanding Tax on Mutual Funds

Before delving into the intricate details of mutual fund taxation, it is crucial to understand the basics. Profits earned from mutual fund investments are termed ‘capital gains’ and are subject to taxation. Therefore, prospective investors should clearly understand how these returns will be taxed while also exploring potential tax deductions available in specific cases.

Factors Determining Tax on Mutual Funds

Several key factors influence taxation on mutual funds. These include:

  1. Fund Types: Taxation rules vary depending on the type of mutual fund, whether it’s an equity mutual fund, debt mutual fund, hybrid mutual fund, or others.
  2. Dividend: Dividends represent a portion of the profit distributed among investors by mutual fund houses. These dividends are subject to taxation.
  3. Capital Gains: Capital gains occur when investors sell their capital assets for a higher price than their initial investment, resulting in a profit.
  4. Holding Period: The duration between the date of purchase and sale of mutual fund units significantly impacts the tax rate. Longer holding periods lead to lower tax amounts.

Earning Returns in Mutual Funds

Returns from mutual funds come in two primary forms: dividends and capital gains. Dividends are distributed to investors when the fund generates a surplus, and the amount received depends on the number of mutual fund units held.

On the other hand, capital gains result from selling mutual fund units at a price higher than the initial investment. Both dividends and capital gains are taxable for mutual fund investors.

Taxation of Dividends Offered by Mutual Funds

Following amendments in the Union Budget of 2020, dividends from any mutual fund scheme are taxed in the classical manner. This means that dividends are added to the investor’s taxable income and taxed at their respective income tax slab rates. Previously, dividends were tax-free in the hands of investors, as companies paid a dividend distribution tax (DDT) before distributing dividends.

Taxation of Capital Gains Offered by Mutual Funds

The taxation rate for capital gains from mutual funds depends on the holding period and the type of mutual fund:

  • Equity Funds: Short-term capital gains (less than 12 months) are taxed at a flat rate of 15%, while long-term capital gains (over 12 months) up to Rs 1 lakh are tax-exempt, with any gains exceeding this limit taxed at 10% without indexation benefit.
  • Debt Funds: Starting from April 1, 2023, debt funds will no longer receive indexation benefits and will be treated as short-term capital gains, taxed according to the investor’s income tax slab rate. Previously, long-term capital gains from debt funds were taxed at 20% with indexation benefits.

Taxation of Capital Gains of Hybrid Funds

The tax rate for capital gains on hybrid or balanced funds depends on the equity exposure of the portfolio. If equity exposure exceeds 65%, the fund is taxed like an equity fund; otherwise, the rules of taxation of debt funds apply.

Taxation of Capital Gains When Invested Through SIPs

Systematic Investment Plans (SIPs) offer a method of periodic investment in mutual fund schemes. The taxation of SIP investments is determined by the holding period. Investments held for over one year result in long-term capital gains, and any gains under Rs 1 lakh are tax-exempt. Short-term gains from SIPs are taxed at a flat rate of 15%, along with applicable cess and surcharge.

Securities Transaction Tax (STT)

In addition to dividends and capital gains taxes, the Securities Transaction Tax (STT) of 0.001% is levied by the government when buying or selling units of equity funds or hybrid equity-oriented funds. Debt fund units are not subject to STT.

Conclusion

In summary, the taxation of mutual funds is influenced by various factors, including the type of fund, holding period, and the investor’s income tax slab rate. To maximize tax efficiency, it is advisable to hold mutual fund units for the long term, as the tax on long-term capital gains is typically lower than that on short-term gains.

Frequently Asked Questions

1. Are mutual fund taxes payable every year?

No, mutual fund taxes are only payable when you redeem units or sell a scheme, not annually. However, dividend income from mutual fund schemes is included in your total income for the financial year and is subject to income tax.

2. Can capital gains tax be avoided?

Capital gains tax cannot be avoided, but investments can be structured to be tax-efficient. Understanding the types of taxes levied on mutual fund schemes is essential.

3. What factors should be considered when choosing tax-saving mutual funds?

Four key factors to consider are the mode of investment, asset allocation, tax-exemption limits, and lock-in period.

4. Can mutual fund investments provide income tax rebates?

Tax benefits are available under Section 80C of the Income Tax Act for Equity Linked Saving Schemes (ELSS), offering deductions of up to Rs. 1.5 lakh and potential annual tax savings of around Rs. 46,800. ELSS investments have a minimum lock-in period of three years.

5. Are wealth taxes applicable to mutual fund investments?

Mutual funds and other financial assets are exempt from wealth taxes under the Wealth Tax Act.

6. What is Section 54EA regarding capital gains tax exemptions?

Section 54EA provides an exemption from capital gains tax when a long-term capital asset is transferred before April 1, 2000, and invested in specific bond shares within six months of the transfer.

7. What are tax-saving mutual funds (ELSS)?

Equity Linked Saving Schemes (ELSS) are known as tax-saving mutual funds that offer deductions under Section 80C of the Income Tax Act. They provide tax-saving opportunities and potential long-term returns.

Sumitha

I'm a professional content creator passionate about writing. My articles span law, business, finance, investments, and government schemes, always simplifying complex topics. Exploring and embracing novelty are my off-duty joys.