Everything you need to know about taxation in mutual funds

Taxation is regarded as one of the most difficult topics to comprehend. However, we have made it easy for you to comprehend the taxes element of mutual funds in this post.

To understand mutual fund taxation, we must first understand how you generate money from mutual funds. As a mutual fund investor, you may make money in two ways: dividends and capital gains. Dividends are a regular source of income supplied by mutual fund schemes from the profits on your investments. Dividends are paid to mutual fund investors in proportion to the number of units they own.

Capital gain, on the other hand, is the profit realised by mutual fund investors when they sell or redeem their mutual fund units. For example, if you invested Rs 10,000 and the value at the time of sale is Rs 20,000, your capital gain is Rs 10,000 (Rs 20,000 less Rs 10,000). However, it is important to emphasise that only realised profits are counted for tax purposes. Furthermore, dividends and capital gains are equally taxable in the hands of mutual fund investors.

Dividends and taxation

Payments were formerly tax-free in the hands of investors since mutual funds paid Dividends Distribution Tax (DDT) before disbursing dividends to investors. Dividends paid by any mutual fund scheme, however, are taxed in the hands of mutual fund investors, according to revisions established in the Union Budget 2020. This means that dividends received by investors should be included in their overall income and taxed at the applicable income tax slab rates.

The taxation of capital gains

Long-term capital gains and short-term capital gains are two types of capital profits. As a result, before we can comprehend how capital gains are taxed, we must first grasp how long-term and short-term capital gains are characterised.

The table above clearly demonstrates how different mutual funds define long-term and short-term capital gains. From a tax standpoint, mutual funds are divided into two major types: equity mutual funds and debt mutual funds, where anything less than 12 months is short-term and anything more than 12 months is long-term for equity mutual funds and anything less than 36 months is short-term and anything more than 36 months is long-term for debt mutual funds.

However, we do have hybrid funds that are a combination of equity and debt. As a result, in order to establish their long- and short-term prospects, we must examine their equity and debt components. If a hybrid fund has at least 65 per cent equity at all times, it is termed an equity fund, and if it contains at least 65 per cent debt, it is deemed a debt mutual fund. Furthermore, the arbitrage fund, which falls under the hybrid category, is normally taxed as an equity fund unless it holds 65 per cent or more in debt securities.

Taxing equity mutual funds

According to the above table, if you sell an equity fund during the first 12 months, it is deemed short-term capital gains and is taxed at 15 per cent plus cess, regardless of your income tax bracket. Furthermore, if you sell an equity fund after a year, profits up to Rs one lakh are tax-free.

This implies that if your long-term capital gains are less than Rs one lakh, you are not required to pay any tax. However, if they exceed Rs 1 lakh, they will be subject to a 10 per cent plus cess (without any indexation advantage) on the excess gains. For example, if your long-term capital gains are Rs 80,000, you do not have to pay any tax, but if they are Rs 1,20,000, you must pay Rs 2,000 in tax (10 per cent of Rs 1.2 lakh less Rs 1 lakh).

Taxing debt mutual funds

Referring back to the previous table, if you redeem units of debt mutual funds before 36 months, it will be regarded short-term capital gains and will be added to your overall income and taxed at your income tax rate. However, if you sell debt funds after 36 months, you will face a 20 per cent tax with an indexation advantage.

Indexation is simply the process of adjusting your purchase price to account for inflation. Gains are determined by subtracting the inflated buying price from the sales price. This minimises your gain (not practically, but for tax purposes), and hence you must pay less tax. The Cost Inflation Index (CII), which is produced each fiscal year, is used to compute the same.

SIPs are taxed differently

The systematic investment plan (SIP) is one method of investing in mutual funds that allow participants to invest a modest quantity on a regular basis - daily, weekly, monthly, quarterly, bi-annually, or yearly. With each SIP, you really acquire a fixed number of units of that fund, and redemption of these units is done on a first-in-first-out basis.

For example, if you invest in an equity mutual fund through a monthly SIP for a year and elect to redeem your whole investment after 13 months, only the units acquired through the SIP in the first month are considered long-term, and you realise long-term capital gains on these units.

If your gains are less than Rs 1 lakh, you are not required to pay any tax. However, the remaining units have not yet finished the 12 months. As a result, you generate short-term capital gains on the units you acquired. These profits would be taxed at a flat rate of 15% plus cess, regardless of your tax bracket. Similarly, debt funds operate in the same manner as equity funds, except the tax treatment applied to debt funds, which is addressed in the section "Taxing debt mutual funds."