Check out How Your Mutual Fund Investments Are Taxed

As a financial instrument, mutual funds are widely considered to be secure, sustainable, and reliable. This is primarily because they are professionally managed, offer a diverse portfolio and are largely cost-effective.

However, a number of people are concerned whether the tax saving mutual funds, actually help to save taxes or it’s just a publicity gimmick. Although there are a number of exemptions and deductions available on most funds, investors aren't usually aware of such details. All they tend to know is that mutual funds aren't taxed at the source. What they aren't told is that even without TDS, investors are not released from the obligation of mentioning the gains that accrue from tax saving mutual funds when they file their IT returns.

This is why it is important to know how mutual fund investments are taxed in India.

What of Taxation?

In India, there are a few essential types of taxation. These are:

- Capital gains- A capital gains tax is charged on the profits or gains which accrue on a mutual fund investment over a certain period.

- Dividend Distribution Tax (DDT)- If your mutual funds yield dividends, the fund house deducts a dividend distribution tax before paying them to you.

- Securities Transaction Tax (STT)- When you sell a mutual fund, an STT is levied at the rate of 0.001%. It is charged on the sale of both, equity and hybrid funds.

So, whether you invest in Equity linked saving scheme (ELSS) mutual funds or any other form of tax saving mutual funds, you will be subject to these three type of taxes. Nevertheless, the specific rate of taxation will vary according to the type of fund that you have invested in and its total holding period.

What Is the Holding Period?

When it comes to tax saving mutual funds, the holding period is defined as the amount of time for which the fund has been held by an investor. It can either be long-term or short-term.

The current guidelines in this regard are:

- Equity Mutual Funds- A period greater than 12 months is considered to be long-term while a period lower than 12 months is considered to be short-term.

- Balanced/Hybrid Mutual Funds- Their holding period is exactly the same as equity mutual funds.

- Debt Mutual Funds- For these, a period greater than 36 months is considered to be long-term whereas a period lower than 36 months is defined as short-term.

- International Funds- The holding period of mutual funds in the international category is just the same as debt mutual funds.

- Other Hybrid Funds- For other funds, if more than 65% of their assets are invested in equity, their holding period would be similar to equity funds. If less than 65% of assets are invested in equity, their holding period would be the same as debt funds.

How Are Mutual Funds Taxed?

The taxation process for the entire mutual fund portfolio can be better understood by undertaking an individual analysis of all the fund types. These include:

Equity Funds

These funds can generally be divided into two types, namely tax saving mutual funds and non-tax saving equity funds.

In the non-tax saving equity funds category, the first Rs.1 lakh earned is completely tax-free. However, a long-term capital gains tax (LTCG) is charged at a rate of 10% at every profit sum earned thereafter. No benefit of indexation is provided. Also, a short-term capital gains tax (STCG) of 15% is levied, if the fund is held for less than 12 months.

In the tax saving mutual funds category, the ELSS mutual funds, are the most efficient vehicles. Under section 80 (C) of the Income Tax Act, 1961, the ELSS mutual funds, which come with a lock-in period of three years offer a tax deduction of about Rs.1.5 lakh.

The dividends obtained on equity funds are taxed at a rate of 10%, whereas the dividends of non-equity funds are levied a tax at the rate of 28.84%.

Debt Funds

The LTCG on debt funds is charged at a rate of 20%. Nonetheless, these rates are subject to indexation. In simple words, indexation is a mechanism which helps to factor in the cost of inflation which occurred between the time when the fund was initially bought and the time when it was finally sold.

The SCGT is not separately charged on profits from debt funds. Instead, it is included within the income tax which is levied on you depending on which specific taxation slab you fall under.

Balanced/Hybrid Funds

The balanced or hybrid funds are tax saving mutual funds as they are treated in exactly the same way as their equity counterparts. You can even purchase the ELSS mutual funds via the balanced fund route if more than 65% of their assets are invested in equity. 

Non-Resident Indians

Unlike other tax saving mutual funds, a TDS is charged from the funds purchased by non-resident Indians. Moreover, STCG and LTCG are also levied upon them. The tax rate for both, equity and debt funds varies for NRIs in the following way:

- Equity (Short-term)- 15%

- Equity (Long-term)- 10%

- Debt (Short-term)- 30%

-  Debt (Long-term)- 20%

Systematic Investment Plans

Last but not least, the systematic investment plan (SIP) is a method which allows the investment of a fixed amount periodically in any mutual fund. This period may range from a fortnight or a month to a quarter or even a year. From the taxation point of view, every SIP is treated as a fresh investment and thus, gains made from each one of them are taxed separately. This can be better understood with the help of an example.

Consider that you begin investing Rs. 10,000 per month as an SIP. After the completion of 12 months, when you want to redeem your money, only the first investment made in the first month and the gains which have accrued from it will be tax-free. The gains procured on all subsequent SIPs would be subject to STCG. This is because, after 12 months only the first SIP would have completed a year. Every other SIP would be treated as a new investment.

The Road Ahead

If the aforementioned taxation system still appears to be too complex, you can easily seek assistance from online platforms like Coverfox. Not only would they help you in determining your total tax liability, but they would also guide you to effectively invest in the best tax saving mutual funds.

Whether you choose to go for an SIP or an ELSS mutual fund, if your primary purpose is tax efficiency, you should try to seek sound advice and proceed cautiously. After all, it is only wise investments which can lay the foundation for high and tax-secured returns.