Taxation in Mutual Funds: What Every Investor Should Know

Mutual funds (MFs) are the most popular investment avenues for Indian investors today. Investing in MF helps you diversify your portfolio and gives potential for good returns. However, the often-overlooked aspect of investing is the taxation in mutual funds. Understanding how your Mutual Fund investments are taxed helps to make informed decisions and maximise post-tax returns.

In this blog, we'll break down taxation in mutual funds in simple terms, covering how it works for different types of funds, what has changed recently, and what you need to be mindful of before investing.

Understanding Taxation in Mutual Funds

In India, taxation in mutual funds primarily depends on two things:

• The type of mutual fund you invest i.e., equity or debt.
• The duration for which you hold the investment (Short-term or Long-term)

Let's explore how MFs are taxed under each category.

Taxation of Equity Mutual Funds

Equity mutual funds are those where a minimum of 65% of their portfolio is invested in equity shares. The taxation of equity mutual funds works as follows:

• Short-Term Capital Gains (STCG): If you sell your units within 1 year, the gains are considered short-term and are taxed at 15%.
• Long-Term Capital Gains (LTCG): If you sell your units after 1 year, these gains are long-term. Gains exceeding ₹1 lakh in a financial year are taxed at 10% without indexation.

This ensures that when you hold equity funds for over a year, you can enjoy lower tax rates.

Taxation in Debt Mutual Funds

Recent changes in tax laws have impacted how taxation in mutual funds works, especially debt-oriented ones. All capital gains from debt funds are taxed as short-term, regardless of holding period. These are now taxed according to your income tax slab rate.

Earlier, holding debt funds for over 3 years gave LTCG benefits with indexation (which adjusted purchase cost for inflation), but this was removed. The change in taxation has made debt funds less tax-efficient compared to before.

Example:

When you invest ₹2 lakh in a debt fund and redeem it after 4 years, at ₹2.8 lakh. The gain of ₹80,000 is taxed as short-term capital gain and added to your income.

What About Hybrid Funds?

Hybrid funds are those MFs that combine equity and debt in varying proportions. Their tax treatment depends on the equity exposure:

• If equity is 65% or more, they are taxed like equity funds.
• If equity is less than 65%, they are treated like debt funds.

So, taxation in mutual funds also varies based on the fund category, even within hybrids.

Are Dividends from Mutual Funds Taxed?

Yes. Since the Union Budget 2020, dividends from MFs are now taxed in the hands of investors.

• The amount received is added to your total income and taxed according to your income tax slab.
• So, if the dividend amount exceeds ₹5,000 in a financial year, a TDS of 10% is deducted by the AMC before payment.

Understanding dividend taxation is an important aspect of mutual fund taxation in India for those who prefer regular income through mutual funds.

Tax-Free Mutual Funds: Are They a Reality?

While no mutual fund is completely exempt from tax, some options give you tax-saving benefits. A notable example is the Equity Linked Saving Scheme (ELSS).

• ELSS funds have a 3-year lock-in period. This means you cannot withdraw the amount before 3 years. It qualifies for tax deduction under Section 80C.
• When you invest in these funds, you can claim a tax deduction of up to ₹1.5 lakh in every financial year.

So, while not exactly tax-free mutual funds, ELSS can help reduce your taxable income, offering dual benefits.

How to manage Mutual Fund Taxation in India?

Here are a few quick tips to help you manage taxation in mutual funds smartly:

• Hold your equity funds for at least 1 year to avail LTCG benefits.
• Use ELSS funds to reduce taxable income under Section 80C.
• Rebalance your portfolio mindfully to avoid triggering taxable events.
• Keep track of dividend income and include it in your annual tax filing.
• Consult a tax advisor if you have complex investment holdings.

When you carefully plan an investment strategy with the tax implications in mind, you can boost the returns earned.

Final Thoughts

Taxation in mutual funds is a major chunk of investment planning that many people overlook. The goal isn't just to earn returns, but to optimise post-tax gains. Whether you're just starting to invest or are experienced, understanding how mutual funds are taxed will help you make better, smarter financial decisions. You can learn about more fund options on Indiabulls Securities Limited (formerly Dhani Stocks Limited).

FAQs

1. How are mutual funds taxed in India?

The tax varies based on the type of MF you invest in and how long you hold it. Equity funds held over one year have long-term capital gains taxed at 10% (above ₹1 lakh), while debt funds are taxed as per your income tax slab regardless of the holding duration.

2. What is the tax rate for dividends from mutual funds?

Dividends are added to your income and taxed as per your slab rate. If the annual dividend exceeds ₹5,000, TDS at 10% is deducted.

3. Can I avoid paying tax on mutual funds?

You can't completely avoid taxes, but you can minimise them by using ELSS funds for Section 80C benefits or holding equity funds for the long term to reduce capital gains tax.

4. What has changed in mutual fund taxation?

Post-April 2023, debt mutual funds lost their long-term capital gain benefits. All gains from debt funds are now taxed as short-term income, i.e., as per your tax slab.

Disclaimer
Mutual fund investments are subject to market risks, read all scheme related documents carefully.