When we look back at the past few decades and how investment patterns and ideologies have changed, one investment vehicle that has gained most prominence, is mutual funds. They have been increasingly becoming one of the preferred investment instruments to achieve life goals and maximise?wealth creation. Thanks to the diverse set of categories and schemes in mutual funds, they are able to offer something for different investors with different needs.
However, amidst the wide gamut of mutual funds and the multiple benefits that await to be unlocked by investors, one aspect that we usually miss out on is that of taxation of mutual funds. Both existing as well as new mutual fund investors are often keen but puzzled about how their investments would be taxed. Let’s answer this Frequently (Not) Asked Question about mutual funds.?
Before we dive deeper into the taxation angle, it’s important to know the two sources of income from mutual funds - Dividend and Capital Gains.
Dividends are primarily paid out of the profits and surplus of the company, if any. The amount received as dividend is proportional to the number of mutual fund units held by the investor. This mode is preferred usually by those preferring regular inflow of income at certain intervals.
As far as their taxation is concerned, prior to the amendments made in Union Budget 2020, dividends were tax-free in the hands of investors, as the companies paid dividend distribution tax (DDT) before sharing their profits with investors in the form of dividends. However, post the amendments in 2020, DDT has been abolished, and dividends received by investors from the mutual fund scheme are added to their taxable income, and taxed according to their respective income tax slab rates.?
Capital gain refers to the profit earned by investors when the selling price of the mutual fund units held by them is greater than the purchase price. Simply put, capital gains are a result of appreciation in the price of the mutual fund units. And such gains attract capital gains tax, whose rate depends upon the holding period and type of mutual fund. Holding period refers to the duration for which the mutual fund units were held by an investor from purchase till sale/redemption.?
Here’s how the holding periods are defined as per the type of mutual fund:
Equity Funds
Short Term-holding period of less than 12 months
Long Term-Holding period equal to or more than 12 months
Debt Funds
Short Term-holding period of less than 36 months
Long Term-Holding period equal to or more than 36 months
Hybrid Funds
If equity-oriented
Short Term -holding period of less than 12 months
Long Term -Holding period equal to or more than 12 months
If debt-oriented
Short Term-holding period of less than 36 months
Long Term-Holding period equal to or more than 36 months
For debt funds, the returns booked on redeeming your investment within 3 years are considered as short-term capital gains, which is included in your annual income and taxed in accordance with your income tax slab. Whereas, the returns booked on investments after 3 years are considered as long-term capital gains and get taxed at 20% with indexation benefits, that is, the purchase price of fund units is adjusted upwards for inflation, while computing the capital gains.
All equity schemes’ gains, including ELSS, are subject to capital gains tax.? Equity mutual funds levy a flat 15% rate of tax on short term capital gains. Whereas long term capital gains (LTCG) are tax free upto Rs 1 lakh in a financial year, and cumulative gains above this limit get taxed at 10%, without any indexation benefit.
As far as hybrid funds are concerned, they are taxed as per the applicable rules for the category they are oriented to, i.e. hybrid equity oriented funds (those funds which have invested? 65% or more of its assets in equity-oriented investments)? would attract taxation as per the rules applicable on equity funds, and hybrid debt oriented funds (those funds which have invested less than 65% of its assets in equity-oriented investments)would attract taxation as per the rules applicable on debt funds.
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