Tax on Mutual Funds

Variables Determining the Taxation for Mutual Funds

The principles of Mutual Fund taxation are much simpler to understand when they are further broken down into smaller pieces.

So let us start by taking a look at the 4 variables that affect the tax liability of Mutual Funds:

1) Types of Funds

Mutual Funds are divided into two groups for tax purposes: Equity-Oriented Mutual Funds and Debt-Oriented Mutual Funds.

2) Capital Gains

When you sell a capital asset for more money than it costs to purchase, you make a profit, known as a Capital Gain.

3) Dividend

A dividend is a portion of accumulated profits that the Mutual Fund house distributes to the scheme's investors; investors do not need to sell their assets to receive a dividend.

4) Holding Period

The tax you will pay on your capital gains depends on the Holding Period. Therefore, less tax will be due if your Holding Period is longer. Because India's income tax laws encourage longer holding times, keeping your investment longer lowers your tax burden.

How Do Mutual Funds Generate Profits?

Mutual Fund investing allows investors to profit from either Capital Gains or Dividend Income. Let us define them and examine their differences in more detail.

Profit from selling an asset for more than its cost is known as a Capital Gain. However, it is crucial to remember that Capital Gains are only realized upon redeeming the Mutual Fund units. As a result, the Capital Gains Tax on Mutual Funds only becomes due at redemption. Therefore, the tax on Mutual Funds redemption must be paid when the upcoming fiscal year's income tax returns are submitted.

Another way for investors in Mutual Funds to receive income from a fund is through Dividends. Based on its accumulated distributable surplus, the Mutual Fund declares Dividends.

When paid to investors, Dividends are distributed at the fund's discretion and immediately subject to taxation. Therefore, when investors receive a Dividend from their Mutual Funds, they must pay tax on it. The following section contains information on the previous and current Mutual Fund dividend tax regulations.

- Taxation of Dividends Provided by Mutual Funds

The Finance Act of 2020 made a change that eliminated the Dividend Distribution Tax. Investors were exempt from paying taxes on dividend income from Mutual Funds until March 31, 2020.

Dividend Distribution Tax (DDT) was deducted by the fund houses that announced dividends before paying them to the Mutual Fund investors. The investor must pay taxes on the entire dividend income according to the income tax bracket under the heading "Income from Other Sources."

The Mutual Fund scheme's dividend is also subject to TDS (tax deducted at source). The AMC is now required to deduct 10% TDS under Section 194K from the dividend that the Mutual Fund distributes to its investors when the rules have changed if the total dividend paid to an investor during a financial year exceeds ₹5,000. You can claim the 10% TDS that the AMC has already taken out when you pay your taxes and only pay the remaining amount.

- Taxation of Capital Gains Provided by Mutual Funds

The holding period and type of Mutual Funds affect the tax rate on capital gains for Mutual Funds. The holding period is the length of time an investor held units of a Mutual Fund. Put simply, the holding period is the time between the date of buying and selling Mutual Funds units.

The following categories apply to capital gains realized on the sale of Mutual Fund units-

- Taxation of Capital Gains Provided by Equity Funds

Mutual Funds classified as equity funds have an equity exposure of at least 65%. As previously stated, when you redeem your equity fund units within a holding period of one year, you realize short-term capital gains.

Regardless of your income tax bracket, these gains are taxed at a flat rate of 15%. When you sell your equity fund units after holding them for at least a year, you realize long-term capital gains. These capital gains are tax-free, up to Rs 1 lakh per year.

Any long-term capital gains over this threshold are subject to a 10% LTCG tax, with no benefit of indexation.

- Taxation of Capital Gains Provided by Debt Funds

Debt mutual funds have entirely different taxation. If a debt investment is sold within 3 years until March 31st 2023, it will be deemed as STCG. This STCG will be added to the income of the investor and would be liable to be taxed according to the tax slab under which the investor falls.

If debt investments' holding period is more than 3 years, it will be termed as LTCG. It will attract an LTCG tax of 20% with indexation benefits. 

Note indexation is applicable to only LTCG that's earned on non-equity-oriented mutual funds. 

Another important thing to note is that the fund manager will levy an STT of 0.001% if you plan to sell your equity fund units. STT is not applicable to the sale of units in debt funds. 

It is essential to remember that debt funds no longer have the benefit of LTCG. The capital gains that arise from such funds will be liable to be taxed according to the tax slab rate under which an investor falls in.

- Taxation of Capital Gains Provided by Hybrid Funds

Whether a Hybrid Fund is equity-focused or debt-focused determines how the Mutual Fund taxes it. All other hybrid funds are debt-focused, while those with equity exposure over 65% are considered equity-focused schemes.

Depending on how much equity exposure they have, hybrid funds may or may not be subject to the same tax regulations as Equity or Debt Funds.

- Securities Transaction Tax or STT

The Securities Transaction Tax is separate from the Capital Gains and Dividend Taxes. When you buy or sell Mutual Fund units of an Equity Fund or a Hybrid Equity-Oriented Fund, the government (Ministry of Finance) will assess an STT of 0.001%. On the other hand, the sale of Debt Fund units is exempt from STT.

Conclusion

In conclusion, investors can learn how Mutual Funds are taxed if they are concerned that their returns from Mutual Funds will be reduced after paying taxes. They can determine what is advantageous for them by calculating how the tax rules for long- and short-term investments in equity and debt funds differ.

By investing in tax-saver funds, they can reduce their tax obligations and corpus generation. Taxation for a type of fund is the same whether it is purchased in a lump sum or through a SIP (Systematic Investment Plan). However, long-term investments may be more tax-efficient than holding the units for a brief period.

Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.