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Tax on Mutual Funds: What Is It and How Does It Work?

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Tax on Mutual Funds: What Is It and How Does It Work?

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There are a whole lot of ways to save taxes. And one of the more popular ones is tax-saving mutual funds. These are essentially mutual funds in which you have to stay invested, but give you up to ₹1.5 lakhs of saving on your taxable income as per Section 80C of the Income Tax Act. But here’s a quick fact - the gains you make on these mutual funds are also taxable. 

Whoops! 

Read on and see what taxes you may be paying on your mutual funds investments.

Let’s also analyse mutual fund tax benefits, tax saving mutual funds and tax on mutual funds.

What are taxes on mutual funds?

Like all income that you earn, the money you earn from Mutual funds is also taxable. Broadly, this could be broken down into the following categories:

  1. Tax on dividends
  2. Tax on capital gains
  1. Tax on Short-Term Capital Gains
  2. Tax on Long-Term Capital Gains

Tax on capital gains can also be divided further based on the type of mutual fund invested in

  1. Tax on Debt Mutual Fund Capital Gains
  2. Tax on Equity Mutual Fund Capital Gains
  3. Tax on Hybrid fund Capital Gains
  4. Tax on Capital Gains from SIP investments
  5. Securities Transaction Tax

Saving on tax through tax-saving mutual funds

You can obtain an income tax exemption on your investment in tax-saving mutual fund schemes. What it means is that the amount that you invest in tax-saving mutual fund schemes will be exempted or not considered as your annual income for that financial year. 

In India, tax-saving mutual funds are also known as Equity Linked Savings Schemes or ELSS. There are applicable limits on how much income tax exemption you may claim. 

With your Fi Money account, you can access various tax-saving mutual fund schemes. You can pick and choose a mutual fund of your choice and easily invest in the fund from the Fi Money app.

On Fi Money, we also have our own version of SIPs called FIT rules. It’s a way of automating your SIP investments based on conditions chosen by you. For instance, you can invest in a mutual fund each time you shop online, or even every day or every week. 

How to choose tax-saving mutual funds:

Tax-saving mutual funds come with their own limitations. Here are a list of some of the factors you should consider before picking a tax-saving mutual fund:

Asset allocation

ELSS funds are mandated to invest at least 80% of their investment corpus in equities. These funds can be either actively managed or passively managed (as per the new SEBI - Securities and Exchange Board of India rule). 

Lock-in period

ELSS funds have a lock-in period of three years. If you invested in an ELSS fund today, you could only redeem or sell your allocated units after three years.

Tax exemption limits

You can get tax exemption for investments in ELSS funds up to ₹1.5 lakhs in a financial year. 

Mode of investment

You may invest ₹1.5 lakhs as a lump sum or via a SIP, i.e. a Systematic Investment Plan in a financial year. 

When you invest as an SIP, you authorise the mutual fund house to deduct an equal instalment at regular intervals for a specific period from your bank account. These instalments are automatically invested in the mutual fund of your choice.

Who may invest?

An individual or a Hindu Undivided Family (HUF) may invest in an ELSS fund to claim tax exemptions.

Risk and Return

Since most of the investments of ELSS funds are in equities, their risk and returns are similar to those of equities. They tend to perform well over long periods. However, they may be more volatile over short to medium periods. 

In the long term, they offer the potential for good inflation-beating returns.

Salient features of ELSS mutual funds

ELSS schemes are well suited to beginners in the world of investments. They offer immediate tax savings in the current financial year along with good returns over three years and more. 

However, they also carry a higher risk than other tax-saving options like Public Provident Fund (PPF). Aggressive, risk-seeking investors and moderate risk-neutral investors with higher risk appetite and risk tolerance may invest in ELSS schemes with a long-term investment horizon. 

Tax on mutual funds

Mutual fund schemes may pass on the returns or gains to investors in two ways or modes: 

  • Dividend 
  • Growth or capital gains

Dividend

After the union budget of 2020, dividends distributed to investors are added to their annual income for that financial year. Investors are now taxed as per their income tax slabs.

Earlier, companies paid dividend distribution tax (DDT) before sharing their profits with investors in the form of dividends. During this period, dividends received from domestic companies of up to ₹10 lakh a year were tax-free for the investors. Dividends above ₹10 lakh per financial year were subject to dividend distribution tax at 10%. 

Growth or capital gains

The tax rate of capital gains from mutual funds depends on how much time you stayed invested in the fund and the asset class of the mutual fund. The amount of time you invested in the fund is called the holding period. The holding period is the time elapsed between the date of the sale and the purchase of mutual fund units. 

Capital gains realised from the sale of mutual funds units are categorised as per the asset class of the fund as follows:

Tax on capital gains from equity mutual funds

For taxation purposes, equity funds are those mutual funds whose equity investments are more than 65%. As listed in the table above, you realise Short Term Capital Gains or STCG when you redeem your equity fund in less than a year. A flat tax rate of 15% is applied to these gains, irrespective of your income tax bracket.

Similarly, you realise Long Term Capital Gains or LTCG on selling your equity fund units after a year or more. Long-term capital gains of up to ₹1 lakh a year are tax-exempt. Any long-term capital gains over and above ₹1 lakh are applied to a Long Term Capital Gains or LTCG tax at 10%. This is without the benefit of inflation adjustment or indexation.

Tax on capital gains from debt mutual funds

For taxation, debt funds are those mutual funds whose debt investments are more than 65%. As enumerated in the table above, you are subject to short-term capital gains on redeeming your debt fund units three years from the investment date. These gains are added to your taxable income for the financial year and are taxed at your income tax slab rate.

When you sell units of a debt fund after three years from the investment date, your gains are called long-term capital gains. A flat rate of 20% is applied to these gains after adjusting for inflation, i.e. indexation. Also, any applicable cess and surcharge on the tax are levied.

Tax on capital gains from multi-asset allocation funds

The tax applied on capital gains from multi-asset allocation funds (or balanced funds) is a factor of how much the equity component of their investment portfolio. If the equity component is more than 65%, the fund scheme is treated as an equity fund for calculating tax. If the equity component is less than 65%, then the tax rules of debt funds are applied.

Taxes are applicable upon sale or redemption of fund units

It is important for you as an investor to know the details of the applicable taxes on your mutual fund investments.

Otherwise, these taxes may turn up to be unexpected unpleasant expenses and may put the goal you had invested in at the risk of being left disappointed.

Table showing taxes on mutual funds

Tax on capital gains from mutual funds invested in as SIPs

A systematic investment plan or SIP is a way of investing in equal installments at regular intervals. The regular intervals may be weekly, monthly, quarterly, bi-annually, or annually.

When you purchase units of a mutual fund through a SIP instalment, the redemption of these units is processed on a First In, First Out or FIFO basis. 

Let’s say you invest in an equity fund through a SIP for 12 months, and you redeem your entire investment after 13 months.

In this case, the units you purchased in the first instalment of the SIP have been held for over one year. For those units, the long-term capital gains tax is applied. If your long-term capital gains in the financial year are less than ₹1 lakh, then they are tax exempt.

However, you have realised short-term capital gains on the units purchased through the SIP instalments from the second month onwards. A flat tax rate of 15% is applied to them irrespective of your income tax slab. You also have to pay the applicable cess and surcharge on it.

Thus, for the sake of tax calculation in mutual funds via the SIP route, every single installment of the SIP is treated as a separate investment.

Securities Transaction Tax (STT)

There is another tax known as the Securities Transaction Tax or STT, which applies to mutual fund investments, and this is apart from the tax on dividends and capital gains. 

STT of 0.001% is levied by the Ministry of Finance, Government of India, when you decide to buy or sell mutual fund units of an equity fund or a multi-asset allocation equity-oriented fund. 

STT does not apply to purchasing and selling debt funds and debt-oriented multi-asset allocation fund units.

To conclude

You can save income tax for a financial year by investing in a tax-saving ELSS mutual fund in that financial year either as a lump sum or as a SIP.

If you analyse the structure of the long-term and short-term capital gains taxes, you might realise that generally, taxes on long-term capital gains are less than those on short-term capital gains.

So, as an investor, if you stay invested for longer periods, it is more beneficial and tax efficient for you.

Frequently Asked Questions (FAQs) 

How do I avoid paying taxes on mutual funds?

You cannot avoid paying taxes on mutual funds.

Instead, you can understand the various taxes on mutual funds and draw your investment plan to be tax efficient in addition to being aligned to your goals and your risk profile.

If you study the structure of the long-term and short-term capital gains taxes carefully, you will understand that generally, taxes on long-term capital gains are less than those on short-term capital gains.

As an investor, if you stay invested for longer periods, it is more beneficial and tax efficient for you. 

If you stay invested for longer periods in mutual fund schemes, you may not be able to avoid taxes, but you may be able to minimise them.

Are mutual funds taxed twice?

No. Mutual funds are treated as pass-through vehicles for income tax, and therefore they do not pay Long Term Capital Gains (LTCG) tax or Short Term Capital Gains (STCG) tax on any stock or bond that they buy or sell. You only pay LTCG or STCG once as an investor in mutual funds. As you can see, mutual funds are not taxed twice.

Do I need to pay taxes on mutual funds every year?

You may be required to pay taxes on your income from dividends of mutual fund schemes. This is because dividend income from mutual fund schemes is added to your total income for the financial year in question. If income tax is applicable on this income, you are required to pay the same.

However, when you opt for the growth options of mutual fund schemes, you are required to pay taxes, if applicable, only when you sell or redeem the units of the mutual fund schemes. Not every year.

How much is a mutual fund taxed?

As described above, the applicable tax on a mutual fund depends on various factors like capital gains or dividends, the asset class of the mutual fund and the period for which the investment is made. 

How do I avoid capital gains tax?

You cannot avoid paying capital gains tax on mutual funds. 

Instead, you can understand the various taxes on mutual funds and draw your investment plan to be tax efficient in addition to being aligned to your goals and your risk profile.

If you analyse the structure of the long-term and short-term capital gains taxes carefully, you might realise that taxes on short-term capital gains are generally more than those on long-term capital gains.

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