Taxation of Mutual Funds and their Effect on Returns

Taxation on mutual funds might be complex for those investors who do not have any prior knowledge of the industry. And planning to invest in mutual fund schemes without knowing the taxation, might lead to a loss of your money in the form of tax.

Did you know that there are many different types of mutual funds schemes, according to their characteristics? Click here to find out more.

Taxes paid on investor’s mutual fund investments typically depend on factors like the kind of mutual fund schemes investors have invested in, the period of investment, and which income tax slab those investors belong to.

While investors carefully evaluate mutual fund investments, they should also remember to look at mutual fund taxation before making the investments.

Apart from taxation, investors should also look at redemption, dividends, etc., and how taxation might affect their returns on investments.

Taxation on Mutual Funds 

Just like the government or an organization levies taxes on people to offer them the best facilities; in the same way, mutual fund companies also charge a fee from their investors for the services they provide, on the investment returns they get. 

Mutual funds impose taxes on capital gains of the investor’s investments. In the same way, the government also imposes taxation on dividends gained by the investors, which is called the Dividend Distribution Tax (DDT). 

Before going deeper into taxation, let us first look at the meaning of DDT and understand the capital gains from mutual fund holdings.

Mutual Funds Dividends Taxation

Dividend distribution tax (DDT) is a liability that an organization needs to pay to the government according to the dividends paid to the company’s investors.

In the financial year of 2019-2020, the DDT rate of 28.84% was paid by the fund managing houses that were managing the mutual funds and not by the investors.

However, in the financial year 2020-2021’s budget, the DDT needs to be paid by the investors and not by the mutual fund houses under the new tax regime.

Capital Gain Tax on Mutual Funds

When investors sell their assets at a profit, the total profit earned is called a capital gain. Capital is the principal investment that was made to purchase the investor’s mutual fund units. 

Let’s take an example to understand what mutual funds capital gains mean.

Suppose, an investor bought some units of a mutual fund for Rs. 10,000. The investor’s capital expenditure, in this case, is the principal amount of Rs. 10,000. If the fund generated a return of 10%, the value of the investor’s investment is currently Rs. 11,000. So the capital gain of the investment is Rs. 1000. 

Therefore, 

Capital Gain = Total Income - Initial Capital.

The capital gain, Rs. 1000, in this case, will be the taxable income.

Also, it is important to note that capital gain tax is only applicable when the fund is sold. If investors continue to stay invested, investors will not have to pay the capital gains tax on mutual funds.

The capital gains tax in India depends on the mutual fund scheme and the structure of the investment. Based on their choice of investments, the investors will have to pay short-term capital gains tax (STCG) or long term capital gains tax (LTCG).

The following table gives an idea of what constitutes short-term and long-term:

Funds	Short term	Long term
Equity	Less than 12 months	12 months or more
Balanced	Equity Oriented - Less than 12 months Debt Oriented - Less than 36 months	Equity oriented - 12 months or more Debt Oriented - 36 months or more
Debt	Less than 36 months	36 months or more

Income tax authorities tax the capital gains, and the quantum of tax to be paid depends on the holding period.

Based on the holding period, capital gains can be categorized under two categories: Long term capital gains and short term capital gains.

Long-Term Capital Gains

Mutual funds offer some schemes for the long run through which investors can save their tax. The Long Term Capital Gain (LTCG) Tax on redemption can save up to Rs. 1 lakh. If LTCG is more than 1 lakhs, the applicable tax is 10% without price adjustment.

Here are some major long term tax saving schemes of the mutual funds:

Tax Saving Equity Fund

An investment in an ELSS fund scheme (Equity Linked Savings Schemes), offers tax immunity to their investors under section 80C of the Income Tax Act. The total savings under 80C offer a maximum immunity of up to Rs.1.5 lakhs. Other mutual fund schemes like LIC, Pension Fund, Children Fund, etc. also offer tax immunity.

If an investor has no other deduction under section 80C of the income tax act, he can invest a maximum of Rs.1.5 lakhs to qualify for tax immunity. If the investor is in the 20% tax slab, he saves tax up to Rs.30,000.

If an investor claims Rs.50,000 immunity on payment of children’s school fees, PF, etc., they can invest Rs.1 lakhs in the ELSS scheme. The maximum permissible tax immunity under 80C is Rs.1.5 lakhs.

The ELSS scheme comes with a lock-in period of 3 years. The investor cannot withdraw the units before 3 years. In case they try to withdraw the fund before the immunity period, mutual fund companies impose a heavy fee on investors.

Short-Term Capital Gains (STCG)

STCG is the tax imposed on the profits generated from the sale of assets that are held for a shorter period of time. The taxation in the short term capital gains is up to 15%.

Below are the short-term capital gain funds which impose different kinds of taxation on them:

Debt Funds

Taxation on short term debt mutual funds is different from the taxation on equity mutual funds in the long run.

If investors sell their debt fund investment in between three years, the profit they gain after selling their fund is considered as the short term capital gain. This short term capital gain is then added to the investor’s income and taxed as per the income tax category applicable to the investor.

If investors sell their debt fund investments after three years, those gains will be considered long-term capital gains. These are subject to the LTCG tax of 20% with indexation (Indexation is the inflation between the period of purchasing and selling the funds) benefit.

The indexation benefit makes investing in debt mutual funds more attractive for investors looking for tax-efficient investment.

In short, indexation helps in reducing tax as it affects the purchase cost. Indexation achieves this by adjusting the capital gains to the Cost Inflation Index (CII). 

It is significant to note that indexation can be applied only to the long-term capital gains earned by the investors by investing in non-equity oriented mutual fund schemes. 

Balanced Fund

In this fund, the fund manager invests approximately 65% of the assets in equity. These funds are taxable based on equity investment. 

Systematic Investment Plan (SIP)

Taxation on this fund typically depends on the investment plan selected by the investors. 

Taxation on SIP investments is done based on every SIP investment. Each SIP is treated as a new investment, and taxes are imposed on their gains separately. 

Suppose, investors, initiate investments in equity funds in the form of SIP of Rs 10,000 a month for 12 months. Every SIP by the investor will be considered as a new investment. 

Hence, after 12 months, if the investors decide to withdraw their entire fund (investments plus gains), all their gains will not be tax-free. Gains earned from the first SIP will be tax-free because that investment would have completed one year of the investment. The rest of the gains will be considered for the short-term capital gains tax.

Final Thoughts

Investors should understand how taxation on mutual funds work before investing in mutual fund schemes and know-how these taxes might affect their returns. 

The taxation in mutual fund schemes is imposed under certain conditions. 

The tax-efficiency in long-term investments is lower as compared to short-term investments. That is why experts in this field suggest investors invest in mutual funds for a longer period. According to them, this will save a lot of tax money, help avoid market fluctuation, and offer higher returns to the investors. 

Investors are suggested to look into things before investing in schemes blindly. It is hence, frequently advised to evaluate and analyze a scheme’s performance and returns consistency before selecting the funds to invest in.