Investing in mutual funds is a smart move for your future and wealth creation. However, taxation on mutual fund returns can seem confusing and daunting at first. But here’s the good news. Understanding how your mutual fund returns are taxed isn’t rocket science.
It helps you keep more of your hard-earned money. This knowledge empowers you to make smarter investment choices and plan with confidence. Let’s simplify these tax rules together.
Why should you care about taxes?
You work hard to earn returns on your investments. But taxes can quietly take a big bite out of your returns. This directly influences your final profit.
Many investors, however, only focus on their pre-tax gains. This is one of the most common and costly mistakes. Always remember, your actual wealth is what remains after taxes. Therefore, you must smartly plan your investments and tax filings in order to boost your final returns.
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What is Taxation on Mutual Funds?
Think of taxation on mutual funds as a small fee on your hard earned returns. You only pay it when you sell your fund units for a gain. The government calls this profit “capital gains.” The exact tax rate isn’t the same for every fund. It depends heavily on the fund type and your investment duration. So, understanding these simple rules helps you plan better and keep more of your earnings.
What are the factors that decide tax on mutual funds?
Your mutual fund tax is not a single number. It is calculated based on a few key factors. Primarily, the type of fund you own is the biggest decider. Equity, debt, and hybrid funds all have different tax rules. Your profit, known as a capital gain, is taxed differently for each.
Another critical factor is your investment duration. This is called the holding period. A longer holding period often leads to a lower tax rate. So, patience can be financially rewarding.
Additionally, if you receive dividends, they are also taxed. However, this tax is handled by the fund house before you get the payment. Understanding these factors gives you the power to plan smarter.
How are dividends offered by mutual funds taxed?
Dividends from mutual funds are no longer tax-free for you. The fund house now pays the dividend directly to you. This amount is then added to your total yearly income.
Consequently, it is taxed at your regular income tax slab rate. So, if you fall in the 30% tax bracket, your dividend is taxed at 30%. This makes dividends less attractive for investors in higher tax brackets. It is crucial to factor this in before choosing a dividend option.
Taxation of capital gains offered by Mutual funds
There are two key factors that decide the taxation on mutual funds. The rules change based on the fund type and how long you held it. Profits from selling your units, known as capital gains, are then sorted into these categories:
1. Equity Funds
For equity-oriented funds (investing over 65% in equities), your holding period is key. Selling within 12 months results in a Short-Term Capital Gain (STCG). This gain is now taxed at a flat rate of 20%.
If you hold your units for 12 months or more, it is a Long-Term Capital Gain (LTCG). Here, gains exceeding ₹1.25 lakh in a financial year are taxed at 12.5%. Please note that the benefit of indexation is no longer available for these calculations.
Aggressive hybrid funds are taxed as equity oriented funds as they invest a major portion (more than 65%) into equities. Other funds like balanced advantage which invests more than 35% but less than 65% in equities if held for 24 months or less will be taxed according to the slab rate, however if you hold them longer then the LTCG will be applied at 12.5%.
2. Debt Funds
The tax rules for debt funds changed significantly for investments made after April 1, 2023. Now, regardless of how long you hold them, your profits are always treated as Short-Term Capital Gains (STCG).
This means your entire profit is simply added to your annual income. It is then taxed according to your personal income tax slab rate.
A Special Note for Older Investments
If you purchased your debt fund units before April 1, 2023, the old rules still apply. Under those rules, selling after a holding period of 36 months qualified as Long-Term Capital Gains (LTCG). These long-term gains were taxed at 12.5% with indexation, a benefit that could lower your tax bill.
Taxation of capital gains when invested through SIPs
A SIP is not a single investment, but a series of smaller ones. Each monthly instalment you make is treated as a brand-new purchase. This means every SIP instalment has its own unique purchase date and cost. Most importantly, each one also has its own independent holding period for tax purposes.
This structure is key when you decide to sell. Redemptions follow the “First-In, First-Out” (FIFO) method. The very first units you purchased are considered the first ones you sell. Let’s simplify this with an example. Imagine you redeem units from a two-year-old SIP.
Your earliest units are over 12 months old, so they qualify for Long-Term Capital Gains (LTCG) tax. However, the units you bought in the last few months are still short-term. Therefore, a single redemption can create both long-term and short-term gains. You must calculate the tax for each type of gain separately based on its applicable rate.
Securities Transaction Tax
Other than that of taxes levied on dividends and mutual funds returns, there is one more tax called securities transaction tax. Usually an STT of 0.1% is being charged by the government whenever you decide to buy or sell your mutual fund units of an equity fund or a hybrid equity oriented fund. In the case of debt funds, there is no such STT.
Conclusion
Understanding taxation on mutual funds doesn’t have to be scary. The key is knowing which fund type you own. Remember the 12-month rule for equity funds. Be aware of the new debt fund rules post-April 2023. Plan your investments with a long-term view. This helps you take advantage of lower tax rates.
Keep track of your purchase dates, especially for SIPs. Consider consulting a tax advisor for complex situations. But with this basic knowledge, you’re already ahead of most investors. Make informed decisions. Let taxes work for you, not against you.
