Like any other asset class, profits from mutual funds are also taxable. Considering this, mutual fund investors must stay updated on how they should pay taxes on their returns from mutual fund investments. Understanding all aspects of taxation in mutual funds can help in not just tax filing but also in tax saving.
To help you save the maximum, this post walks you through various elements of taxation in mutual funds.
How Mutual Funds are Taxes in India
Tax saving in mutual funds depends on a variety of factors. Here are the three primary factors that determine the tax liability of mutual fund gains:
Holding period: The holding period determines the tax rate you are liable to pay on your capital gains. The longer the holding period, the lower the tax you pay.
Fund type: From a tax perspective, mutual funds have two categories: debt-oriented and equity funds.
Type of gains: Mutual fund gains are classified into two categories: dividend and capital gains. Dividend refers to a part of your profit generated from the mutual fund house and is distributed to the investors of the schemes. To receive dividends, you don’t need to sell your assets. On the other hand, capital gains refer to the earnings you receive by selling a capital asset for a higher price than its purchasing cost.
Understanding Taxation on Capital Gains and Dividends
Now that you are aware of the determiners, here’s a brief explanation of how taxation on capital gains and dividends works. It can help you choose tax saver mutual funds for your investment portfolio:
Taxation on Capital Gains
The concept of taxation on mutual funds from capital gains is a bit complex. The types of schemes you have invested in and their holding period determine the tax payable on capital gains. Usually, capital gains are categorised into two classes: long-term capital gains and short-term capital gains.
Long-term capital gain (LTCG) usually generates from asset classes you hold for longer. Likewise, a short-term capital gain (STCG) is generated on assets you hold for a relatively shorter period. However, the terms may interpret differently for debt and equity schemes for tax purposes.
For example, for mutual funds, capital gains can be treated as long-term when your holding period is more than 12 months for equity-oriented schemes. On the other hand, for debt-oriented schemes, it's 36 months. You can refer to the following chart to understand this concept better.
| Type | LTCG Holding Period | STCG Holding Period |
| Debt Funds | > 36 months | < 36 months |
| Equity Funds | > 12 months | < 12 months |
| Hybrid Funds | > 12 months | < 12 months |
Understanding the Taxation on Capital Gains Based on Scheme Orientation
While there are two primary categories of mutual funds: debt and equity, it’s crucial to understand hybrid funds as well. This will help you gain better clarity on the taxability of mutual funds for each category. Let’s delve deeper!
Taxation on equity funds: Mutual fund schemes that invest at least 65% of their corpus in equity-related instruments are referred to as equity-oriented schemes. The long-term capital gains on equity schemes are currently taxed at 10% if the gain is above ₹1 lakh. In other words, LTCG up to ₹1 lakh are tax exempted and the additional gains will be taxed at 10%. On the other hand, the STCG is taxed at 15% flat.
Taxation on debt funds:
From April 1, 2023, capital gains generated from debt mutual funds that invest less than 35% in equities, are being considered to be a part of your income and will be taxed as per your individual income tax slab rate. It means the LTCG or long-term capital gains tax and indexation benefits are no longer available on debt mutual funds.
Taxation on hybrid funds: The taxation for gains from hybrid funds typically depends on its focus. To clarify, a hybrid fund with an equity exposure of 65% or more is considered equity-focused and the rest funds are considered debt-focused. For equity-focused funds, LTCG is charged at 10% over ₹1 lakh and STCG is charged at a flat 15%. On the other hand, debt-focused funds involve a tax rate of 20% on capital gains. However, it includes indexation benefits. The taxation on STCG, on the other hand, is measured according to your tax slab.
Taxation on Dividends
According to the amended Finance Act 2020, dividend income from mutual funds is taxable. Fund houses that declare dividends are required to deduct a dividend distribution tax before paying out to the mutual fund investors. The total dividend income is taxable according to the investor’s income tax slab, and they are counted as “income from other sources.”
When paying your dividend, the AMC deducts 10% TDS under section 194K when the dividend amount exceeds ₹5,000 for a specific financial year. However, you can claim the said percentage while paying your taxes and pay the remaining balance. Using a good TDS calculator may help you calculate your dividend income tax appropriately.
Declaring Mutual Funds Capital Gains in Your Income Tax Return
When redeeming your mutual fund investments, it's crucial to declare the details in your ITR. This will require every little detail, including the purchase date of the fund, the date of sale, the money earned and more.
Ideally, you should use a good calculator or tool to automate these computations. This will help you segregate and perform flawless calculations. When declaring your investments and gains, you can pick up from ITR2 or ITR3, depending on your profession (salaried/self-employed/business).
Conclusion
Taxation on mutual funds is not always as complicated as it sounds. A little bit of research may help you figure out how things work. Consequently, you can determine what is good for you. You can also consider comparing tax saver mutual funds to reduce your tax obligations.
Disclaimer
The investment options and stocks mentioned here are not recommendations. Please go through your own due diligence and conduct thorough research before investing. Investment in the securities market is subject to market risks. Please read the Risk Disclosure documents carefully before investing. Past performance of instruments/securities does not indicate their future performance. Due to the price fluctuation risk and the market risk, there is no guarantee that your personal investment objectives will be achieved.