Index funds are a type of mutual funds where the portfolio is made up of securities that are included in the benchmark index. For example, an index fund that replicates the Nifty 50 will comprise of stocks from the Nifty 50 index.
It is a passive style of fund management and hopes to replicate the performance of the benchmark index. Index funds are also taxed like other mutual funds.
How are index funds taxed?
Taxes on index funds are levied both on capital gains and dividends. The dividends are calculated along with the taxable income of the investor and the entire income is taxed at the rates decided for that category.
Capital gains, on the other hand, are taxed separately. The length of time the fund is held is taken into consideration. Tax is only payable when the units are redeemed.
For a short term holding period of twelve months or less, a tax rate of 15% is charged. However, for a long-term holding of more than twelve months, a tax rate of 10% is charged if the gains exceed ₹1,00,000. This includes direct equity and equity mutual funds. Cess of 4% is additionally levied on both the taxes.
How do index funds help minimise taxes?
- People often choose index funds for long-term investing, which means that there is less buying and selling, which results in less payable gains, and hence are often exempt from the more expensive short-term capital gains tax.
- Index funds hold a large number of securities. The fund manager can choose to sell those with the lowest tax slab.
- Most index funds pay lower dividends than actively managed funds, which in turn contributes less to an investor’s total income and automatically reduces tax liabilities.
Index funds are considered effective as they offer reasonably predictable returns as well as tax benefits .
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