Income Tax on Mutual Funds: A Complete Guide

Mutual funds are a popular investment option in India, known for their ability to provide diversification and professional management. However, understanding the tax implications on mutual funds is crucial for every investor. Let’s dive into the details of income tax on mutual funds, helping you navigate this complex terrain with ease.

What is Tax on Mutual Funds?

When investing in mutual funds, investors must consider the tax implications. Any profit investors may make when selling mutual fund units is known as capital gains. Based on how long investors hold the units, these gains are classified into short-term and long-term.

Short-term gains apply if investors hold the units for less than three years. They are taxed according to your Income Tax Rate. On the other hand, gains from units held for more than three years are categorized as Long-Term Capital Gains (LTCG) and are taxed accordingly.

Taxation Of Mutual Funds

Tax on mutual funds is the tax you pay when you invest in mutual funds. If you sell your mutual fund units within three years of buying them, any profit you make is called short-term capital gain and is taxed according to your income tax rate. But if you keep your mutual fund units for more than three years before selling, the profit is called long-term capital gain and is taxed differently.

Key Factors That Determine the Mutual Fund Taxation in India

Breaking down the concepts of mutual fund taxation further into smaller bits makes it far easier to understand. So, let’s take our first step by looking at the three factors that influence mutual fund tax liability.

• The type of funds: For taxation, mutual funds are classified into two categories: equity and debt-oriented  mutual funds.
• Capital gains: Capital gains are the gains you generate when you sell a capital asset for a higher price than its cost.
• Dividend: A dividend is a part of the profits accumulated that the mutual fund house distributes to the investors of the scheme (i.e., dividends don’t require an investor to sell the asset).
• Holding period: The holding period dictates the rate of tax you’ll pay on your capital gains. The greater your holding period, the less tax you’ll pay. India’s income tax regulations encourage a longer holding period, which is why holding your investment for longer reduces your tax liability.

Taxation on Mutual Fund Capital Gains

The tax on mutual funds depends on the type of mutual fund you invest in and how long you hold the units. Let's break down these two factors.

First, let's understand long-term capital gains (LTCG) and short-term capital gains (STCG). LTCG is the profit you make from an asset you hold for a long time, while STCG is the profit from an asset you hold for a short time.

The meaning of "long" and "short" depends on whether your mutual fund is equity-oriented or debt-oriented. For equity mutual funds, gains are considered long-term if you hold the units for at least 12 months. For debt mutual funds, gains are considered long-term if you hold the units for at least 36 months. Here's a quick overview:

How are Mutual Fund Returns Earned? 

Mutual fund investing allows investors to benefit from either capital gains or dividend income. Let’s define these terms and explore their differences.

• Capital Gains: Capital gains refer to the profit from selling an asset for more than its purchase price. This gain is realized in mutual funds only when the fund units are redeemed. Consequently, the capital gains tax on mutual funds is payable when redemption becomes due for the upcoming fiscal year’s income tax returns.
• Dividends: Another way investors earn from mutual funds is through dividends. These are payments made to investors from the fund’s distributable surplus. When investors receive dividends from their mutual funds, these are immediately subject to taxation. Thus, investors must pay tax on the dividends received.

Taxation of Capital Gains Offered by Mutual Funds

Taxation on Dividends Offered by Mutual Funds

Tax on Mutual Fund Redemption 2024

Taxation of Capital Gains When Invested Through SIPs

When you invest in mutual funds through SIPs (Systematic Investment Plans), the taxes you pay on the money you make (capital gains) depend on how long you hold the units.

When you sell (redeem) the mutual fund units bought through SIPs, the units bought first are considered sold first (first-in-first-out basis). If you sell units that you’ve held for more than one year, the gains are treated as long-term capital gains. Long-term capital gains up to Rs 1 lakh are tax-free.

However, any gains from units held for less than one year are treated as short-term capital gains and taxed at a flat rate of 15%, plus any applicable cess and surcharge. This short-term capital gains tax applies no matter which income tax bracket you fall into.

FAQs on Mutual Fund Taxation

How much tax do I pay on mutual funds?

A. The total tax that you have to pay depends on the type of mutual fund you hold. For instance, gains from equity funds and hybrid equity-oriented funds are taxed at 15% plus cess and surcharge if they are held for less than one year. If they are held for more than one year, the gains above Rs 1 lakh in a financial year are taxed at 10% plus cess and surcharge.

On the other hand, from April 1, 2023, debt funds and hybrid debt-oriented funds are taxable as per your income tax slab rate, irrespective of the holding period.

How is short-term capital gains tax calculated on mutual funds?

1. Short-term capital gains tax is calculated on profits from mutual fund units sold within three years of purchase. For equity funds, it is taxed at 15%. For example, if you bought units for ₹100,000 and sold them for ₹120,000, the STCG is ₹20,000, and the tax is 15% of ₹20,000, which is ₹3,000.

Are dividends from mutual funds taxable?

1. Yes, dividends from mutual funds are taxable. However, equity mutual funds specified under Section 10(23D) are exempt from dividend tax. For other funds, dividends are taxed according to the investor’s income tax slab.

What is the tax treatment for long-term capital gains on mutual funds?

1. For equity mutual funds, long-term capital gains exceeding ₹1 lakh are taxed at 10% without indexation benefits. For debt mutual funds, LTCG is taxed at 20% with indexation benefits, which adjusts the purchase price for inflation.

How to avoid capital gains tax on mutual funds in India?

1. To minimize capital gains tax, consider the following strategies:

• Invest in equity mutual funds to take advantage of the ₹1 lakh exemption on LTCG.
• Invest in Equity Linked Savings Schemes (ELSS) to benefit from tax deductions under Section 80C.
• Plan your redemption to optimize tax liabilities based on the holding period.

How to use a mutual fund tax calculator?

1. A mutual fund tax calculator helps estimate your tax liability. Enter details like purchase price, sale price, and holding period. The calculator will compute your STCG or LTCG and show the applicable tax based on current rates.

What exemptions are available under Section 10(23D) for mutual funds?

1. Mutual funds specified under Section 10(23D) are exempt from dividend tax. This section covers mutual funds approved by the Central Government, providing tax relief on dividends received.

How do recent tax changes affect mutual fund investments?

1. Recent changes, such as the Budget 2023 amendments, introduced a tax on LTCG exceeding ₹1 lakh in equity mutual funds. This affects investment strategies, making it crucial to consider tax implications while planning investments.

What are the common mistakes in reporting mutual fund income?

1. Common mistakes include:

• Failing to report STCG in the tax return.
• Incorrectly calculating indexation benefits for LTCG.
• Overlooking dividend income in the ‘Income from Other Sources’ section.

How to report mutual fund income in my tax return?

1. Report mutual fund income in the following manner:

• Include STCG and LTCG under the Capital Gains section.
• Report dividend income under ‘Income from Other Sources’.
• Ensure all income and gains are accurately documented to avoid discrepancies.

Conclusion

Understanding the tax implications of mutual funds is essential for investors in India. By knowing the differences between short-term and long-term capital gains, and how dividends are taxed, investors can make informed decisions to optimize their tax liabilities and maximize returns.

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Author- Bhagyashri Bonde  

Bhagyashri is a seasoned personal finance content writer with a keen expertise in credit cards, personal loans, budgeting, saving, and investing. With 4 years of experience in the financial sector, she has a knack for breaking down complex financial concepts into easy-to-understand advice. Her insights on personal finance management and smart saving strategies have helped our countless readers make informed decisions. Bhagyashri’s passion lies in empowering individuals to achieve financial stability and success through practical tips and actionable advice. Follow her for the latest updates on money management and investment opportunities.