There is a lot of news coverage on Mutual Funds, especially with its increasing advertisements and recommendations by “experts.” According to Investopedia, a mutual fund is a financial vehicle made of a pool of money collected from investors to invest in assets like stocks, money market instruments, bonds, and other assets.” To put it in simple terms, mutual funds are investments managed by mutual fund managers, who use the money of the general public (known as a pool of funds) to invest in various kinds of securities.
They are considered safer than most securities, including stocks, commodities and crypto, and are regulated by SEBI (Securities and Exchange Board of India). A big part of the youth and middle-aged working people are investing most of their hard-earned savings in mutual funds to achieve financial freedom and build wealth, so it is essential to know the tax implications of Mutual Funds. Taxes on mutual funds depend on your type of gains and the duration of your holding, which will be discussed in detail in this article. So, let’s understand how the tax on mutual funds work.
- Tax on mutual funds is levied on all your gains.
- Such gains are made in two forms: capital gains and dividends.
- All the dividends received by a mutual fund investor shall be taxable in his name at their standard tax slab.
- In the case of capital gains, profits are taxed as per the type of investment and the holding period.
Learn the Basics
Mutual funds are managed by mutual fund managers—people who have significant experience managing the public’s money. They also have a deep understanding of financial assets (stocks, bonds, money markets, etc.) they invest money in. So, if we invest in mutual funds, we are handing over our money to mutual fund managers who will invest it on our behalf in exchange for a small fee.
An essential aspect of building wealth via mutual funds includes planning for taxation. Once you know how a tax on mutual funds works, you can assess your situation and plan for taxation.
Tax is paid on the money we earn from any source, including money earned by investing in mutual funds, which happens in two ways:
- Returns via Capital Gains
- Return via Dividends
Returns in the form of Dividends
One of the ways in which a business utilises its excess profits is in the form of declaring dividend among the shareholders of the company.
According to the amendments of the Union Budget of 2020, dividends received by anyone via any mutual fund scheme shall be taxed as per their tax slab rate. Earlier, dividends were tax-free for investors because companies declaring such dividends used to pay tax on their behalf in Dividend Distribution Tax (DDT) before paying out the dividends.
Dividend received from foreign companies gets taxed in India and the home country of the foreign company. But if tax has been paid twice (i.e. in both countries), taxpayers can claim tax relief for the same.
Returns in the form of Capital Gains
Capital gains are the profit made by investors when they sell the security at a higher price than they bought. In more simple terms, capital gains show up when the price of the mutual fund units increases.
The capital gain tax on mutual funds depends on the type of mutual fund and the holding period of investors. The holding period is the period for which mutual fund units are kept by an investor, i.e. the period between the date of purchase and date of sale of mutual fund units.
Capital gain tax on mutual funds is decided as per the type of mutual and the type of gain, which is as follows:
When it comes to capital gains, the rate of taxation depends on the type of funds as well as the holding period, which goes like this:
Taxation of Capital Gains of Equity Funds
Equity funds are those mutual funds which hold more than 65% of their portfolio in equities. We can make short-term capital gains by selling our equity fund units within one year of purchase. Such gains get taxed at 15% flat, irrespective of the income tax bracket.
Long-term capital gains are earned by selling equity fund units after 1 year of holding. Such capital gains, up to INR 1 lakh annually, are tax-exempt. Long-term capital gain of more than one lakhs gets taxed as LTCG tax at 10%, without indexation benefit.
Taxation of Capital Gains of Debt Funds
Debt funds are mutual funds with more than 65% debt exposure. You get short-term capital gains by selling your debt funds within three years of purchase. These gains get added to our taxable income and taxed at our income tax slab rate.
Long-term capital gains get secured by selling debt funds after three years of purchase. Tax on debt mutual funds is charged at 20%, plus cess and tax surcharge.
Taxation of Capital Gains of Hybrid Fund
Taxation of capital gains on hybrid funds depends on portfolio exposure to equities. If equity exposure exceeds 65%, the fund is taxed as an equity fund. Otherwise, it is taxed like debt funds.
Taxation of Capital Gains When Invested Through SIPs
Systematic investment plans or SIPs is a way of investing commonly used in mutual funds. They allow investors to invest a fixed amount of money periodically (usually monthly) in a mutual fund scheme. Many times, investors can choose the frequency of this investment. This frequency can be weekly, monthly, quarterly, half-yearly or annually.
If you hold these for more than a year and enjoy long-term capital gains, such gains up to INR 1 lakh are tax-free. However, short-term capital gains are taxed at a flat 15% plus cess and surcharge.
Securities Transaction Tax (STT)
Along with tax on capital gains and dividends, Securities Transaction Tax (STT) of 0.001% is also levied when buying or selling mutual funds.
Did you know?
- Payment of Dividend Distribution Tax (DDT) for businesses included a surcharge of 12% and cess of 4% and was abolished on April 1, 2020.
- Securities Transaction Tax (STT) of 0.001% does not apply to the sale of debt mutual funds.
- If you are salaried and have no capital gains yet, you shall fill out the Form 1 and form 16. But if you have enjoyed capital gains, you shall fill Form 2.
Word to remember
If you need to understand one term for investing, just remember diversification. Diversification means that you invest your money in different types of securities to protect your portfolio from colossal downside.
For example, if you invest everything in oil and oil goes down, your entire portfolio will be wiped out. So, it is best to invest with a good amount of diversification. Some mutual fund schemes allow significant diversification for their investors.
Getting started in mutual funds can be intimidating and confusing, and tax provisions confuse people further. But with the help of this article, it might have become easier for you, as now you know that mutual funds attract different types of taxes, depending on the type of income and the holding period.
The general rule is that your mutual funds will become more tax-efficient the longer you hold them. This is so because the tax on long-term capital gains is significantly lower than a tax on short-term gains.
It is also advised to invest in mutual funds to diversify your portfolio. This helps you take advantage of growing sectors and industries and limit your losses when some industries face challenges.
SEBI regulates mutual funds, and mutual fund managers have to follow strict guidelines because they manage the money of the layman. Though mutual funds are not 100% safe, and you can lose money, the chances of this happening are slim.
There is no best or worst mutual fund; it depends on various factors, including your risk tolerance, your expected returns and your time frame of investing.
Some mutual funds are illiquid, so you cannot pull out your money within the lock-in period (period for which your money locks and you cannot withdraw). But most mutual funds are liquid, and you can withdraw any time you want.
Yes, mutual fund companies disclose to the investors the name of their mutual fund managers, and you can know about that manager from various sources.
The returns of mutual funds depend on various factors, including the assets it invests in, the approach of mutual fund managers, market conditions, level of diversification, and more. Similarly, the performance of index funds depends on a lot of factors. This makes it almost impossible to predict which one will perform better in the long term.