As investors, we often overlook taxes on our investment returns. The reason being, tax rates vary for different asset classes, which can make things complicated. For debt mutual funds, we need to be aware of two types of taxes on investment gains: short-term capital gains tax (STCG) and long-term capital gains tax. In this article, we will focus on STCG for debt mutual funds. But first, let's define what STCG means for debt-oriented mutual funds.

Types of Capital Gain

Capital Gains

• Capital gains are earnings or losses resulting from the sale of a capital asset. The gain will be taxed under the Income Tax Act of 1961, since it is deemed income. Furthermore, the gain will be taxed in the year the asset is transferred.

Debt Mutual Funds

• Short-term capital gain (STCG) on debt-oriented mutual fund implies that the investment was held for less than 36 months. Long-term capital gain (LTCG) tax will apply if you hold this investment for anything over 3 years. LTCG on debt funds is generally considered more tax efficient since you get the benefit of indexation.

Equity Funds

• In the case of equity funds, any investment held for less than a year will be subject to STCG if redeemed.

Example:

Taking forward the above example, if you invest ₹10 lakh in an equity mutual fund and sell it before one year, you will be charged a 15% short-term capital gains tax, which comes up to ₹1.5 lakh. Additionally, you will also have to pay Securities Transaction Tax (STT), which must be paid by investors when they buy or sell equity funds.

If you invest ₹10 lakh in a debt mutual fund and sell it before three years, you will be charged a 30% short-term capital gains tax, which comes up to ₹3 lakh. It's important to keep in mind the tax implications when making investment decisions, especially for debt-oriented mutual funds.

Changes in Taxation of Debt Mutual Funds

Effective from April 1, 2023, the Indian government has eliminated the indexation benefit previously available for long-term capital gains on debt mutual funds. This change in taxation will impact investors who hold debt-oriented mutual funds as a long-term investment.

Tax Liability

The tax you pay on short-term capital gains from debt mutual funds depends on your income tax rate. This means that your gains get added to your taxable income for the year and taxed accordingly.

The tax rate for short-term capital gains varies depending on your income tax bracket and can be as high as 30%. Even if you're not in the top tax bracket, you'll still have to pay a significant amount of taxes.

To give an example, if you're in the 15% tax bracket and you sold debt fund units before three years, you'll have to pay a 15% short-term capital gains tax on ₹1.3 lakh.

Conclusion

To sum up, it's important for investors to know about taxes on returns, especially for debt mutual funds. If you hold investments for less than 36 months, you'll have to pay short-term capital gain tax (STCG). The amount of tax you'll have to pay depends on your income tax slab rate, which can be as high as 30%. So, before investing in debt-oriented mutual funds, make sure to think about the taxes you'll have to pay and how they'll impact your investment decisions.

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Frequently Asked Questions

1. How is short-term capital gains tax calculated on mutual funds?

Taxation on funds varies based on the fund type and holding period. The following are the differences in taxation between equity and debt funds:

1. Equity funds - Short-term capital gains on equity funds traded on recognised stock exchanges are taxed at 15% under Section 111A. These funds are also subject to Securities Transaction Tax (STT), which investors must pay when buying or selling funds. Long-term capital gains tax (LTCG) is applied at 10% with no indexation.
2. Debt funds - Short-term capital gains on debt funds are added to the investor's income and taxed accordingly based on their income tax bracket.

2. How can you avoid STCG tax on mutual funds?

For equity and debt mutual funds, there's no current way to avoid capital gains tax on your short-term returns. If you make short-term gains from debt funds, you'll pay capital gains tax at the applicable income slab rate.

3. How are debt mutual funds taxed in the short term?

Debt fund gains sold within three years are taxed at the investor's income tax rate.

4. What is the long-term capital gain on the debt fund?

Debt fund units sold after 3 years are taxed at a 20% flat rate with additional cess and tax surcharges. Indexation benefits apply.

5.How much short term capital gain is tax free?

Short-term capital gains are taxable, but some income levels are exempt from paying taxes on STCGs. These include:

• Residents who are 80 years or older with an annual income up to ₹5 Lakh.
• Residents who are between 60 and 80 years old with an annual income up to ₹3 Lakh.
• Residents who are younger than 60 years old with an annual income up to ₹2.5 Lakh.
• Hindu Undivided Families (H.U.F) with an annual income up to ₹2.5 Lakh.

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