Tax On Mutual Fund – How Mutual Funds Returns are Taxed

Mutual funds are among the most sought-after investment options today because of their potential returns and diversification benefits. However, like any other financial instrument, mutual funds are taxed. Taxation on mutual funds is an essential topic in financial planning and in realizing the best return from investments.

In this article, we will understand the current tax on mutual funds and find answers to questions such as “Is investment in SIP tax-free?” Read on.

An Overview of Taxation on Mutual Funds

Tax on mutual funds differs from other sources of income based on various considerations, such as the nature of the mutual fund, holding period, and kind of returns. It is generally charged on capital gains, which are the earnings arising from the sale of units and dividends earned. All categories of mutual funds have different rules; hence, investors must be well-versed in these differences so as to avoid being surprised by tax liabilities.

Factors Affecting Taxation of Mutual Funds

Several factors determine the tax treatment of mutual funds:

Type of Fund:

The tax laws vary for equity, debt, and hybrid funds.

Holding Period:

This is the time period during which the investment is held. Depending on the holding period, gains are treated as short-term or long-term.

Tax Bracket of Investor:

Dividends and some gains are taxed based on the individual’s tax slab.

Dividends vs. Capital Gains:

The mode of return (dividend payout or capital appreciation) affects the taxability.

How Mutual Generate Returns for Investors

Mutual funds make money in the following ways:

Capital Appreciation:

The net asset value (NAV) of fund units increases when units are sold at a higher price, which generates capital gains.

Dividends:

Some funds pay a part of their earnings to the investors in the form of dividends.

Interest and Coupons:

Although this is one of the lesser-known factors, it is also a factor of consideration. Debt funds earn returns through interest or coupons from underlying bonds and securities.

Investors must understand the sources of returns to assess their tax obligations effectively.

Tax Implications of Dividends from Mutual Funds

Tax on dividends from mutual funds will depend on the investor’s slab of tax. These are regarded as “Income from Other Sources” in the tax return of an investor.

Earlier, the dividends received by investors were tax-free. Still, the liability of paying taxes has now fallen on the recipient, making it crucial to factor this while planning for investments.

Capital Gains Taxation Across Fund Categories

Capital gains taxes are based on the holding period and type of fund. The table below summarises the tax treatment:

Fund Type	Holding Period for STCG	STCG Tax Rate	Holding Period for LTCG	LTCG Tax Rate
Equity Funds	< 12 months	20%	≥ 12 months	12.5% (on gains > ₹1.25 lakh/year)
Debt Funds	< 36 months	As per the income tax slab	≥ 36 months	12.5% (Indexation benefit removed)
Hybrid Funds	Varies (equity or debt)	Varies (equity or debt)	Varies (equity or debt)	Varies (equity or debt)

Investors should assess their portfolio’s composition and holding period to determine applicable tax rates. This consideration will ensure your estimates from the investment. You can understand how much your investment’s returns would be chipped away as taxes.

Capital Gains Taxation on Equity Funds

Equity fund capital gains are categorized as follows:

• Short-Term Capital Gains (STCG): Gains on units held for <12 months are taxed at a flat rate of 20%.
• Long-Term Capital Gains (LTCG): Gains on units held for ≥12 months are taxed at 12.5%, applicable to gains exceeding ₹1.25 lakh in a financial year. Gains up to ₹1.25 lakh remain tax-free.

Capital Gain Taxation on Debt Funds

Debt fund capital gains are taxed as follows:

• Short-Term Capital Gains (STCG): Gains on units held for <36 months are taxed as per the investor’s income tax slab.
• Long-Term Capital Gains (LTCG): Gains on units held for ≥36 months are taxed at a flat rate of 12.5%. The indexation benefit, which adjusted the purchase cost for inflation, has been removed.

Capital Gains Taxation for Hybrid Mutual Funds

Hybrid funds are also known as balanced funds. They invest both in equity and debt, but their taxation is calculated according to the equity exposure they have:

• Equity-oriented hybrid funds are treated like equity funds for tax purposes.
• Debt-Oriented Hybrid Funds: Taxed like debt funds.

An investor must analyze the fund’s asset allocation to determine the tax he will have to pay.

Conclusion

Taxation of mutual funds is complex. However, understanding the rules helps an investor make the right decisions. Aligning the investment strategy with tax laws will assist investors in maximizing returns and minimizing liabilities. Always consult a financial advisor or tax expert to tailor your strategy to your specific needs. Only when you align your financial objectives, investment goals, and risk tolerance with the investment in mutual funds, you can come to the right estimates.

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