Understanding Taxation on Equity, Debt and Mutual Funds in India

The buzz of mutual funds has taken the market by storm, especially in India. Investor’s interest in mutual funds has surged in recent years, offering a compelling alternative to traditional investment avenues like fixed deposits and stocks. Mutual funds provide diversification, professional management, and potentially higher returns, making them a popular choice for investors of all stripes.

Investing in FDs can often lead investors to significant tax deductions, especially when they come under the highest income tax bracket. Contrary, when you invest in mutual funds, what comes with it is money management expertise and tax-efficient returns. 

But before you dive headfirst into the world of mutual funds, it’s crucial to understand how taxes impact your returns. This blog will delve into the taxation on Equity and Debt Mutual Funds in India, helping you make informed investment decisions.

What is Tax on Mutual Funds?

Tax on mutual funds refers to the taxes levied on the gains earned from mutual fund investments. The tax treatment varies based on the type of mutual fund and the holding period of the investment. Any benefits gained from investment in mutual funds are popular as ‘capital gains’. These capital gains may be subject to a deduction of tax. 

Hence, before investing in mutual funds, it is important to clearly understand how your return will be taxed. In addition, investors can also avail of those deductions of taxes in some cases. 

5 Key Factors Affecting Mutual Fund Taxation in India:

It is crucial to understand the factors that influence the taxation on your mutual funds. Here is the list of components that affect taxation levied on mutual funds:

• Type of Fund: Equity Funds enjoy tax benefits for long-term investments (over 1 year), while Debt Funds have different tax structures based on recent changes.
• Capital Gains vs. Dividends: Capital gains (profit from selling units) are taxed differently from dividends (fund’s profit distributed to investors).
• Holding Period: Short-term capital gains (held less than 1 year for Equity or 3 years for Debt) are taxed at a higher rate compared to long-term capital gains.
• Dividend Option (Equity Funds Only): The chosen dividend option (receive or reinvest) can impact your tax calculations.
• Your Tax Slab: The tax you pay on capital gains from Debt Funds and short-term capital gains from Equity Funds depends on your income tax slab rate.

Remember: Consulting a tax advisor and staying updated on tax regulations is crucial for optimising your mutual fund investments.

Also Read: Things to Save Tax

How to determine taxes on mutual funds ?

Mutual fund investing offers multiple benefits from either Dividend income or capital gains. Benefits booked on selling the mutual fund units are known as Capital Gains. Hence, capital gains taxation is applied when investors opt for mutual funds redemption and it is essential to pay taxes while filing the ITR for the upcoming fiscal year.

The other income source is dividends. When investors get the dividend, it automatically becomes subject to taxation. Here is explained how current and previous mutual fund dividend taxations function:

Taxation of Dividends Provided by Mutual Funds

As per India’s Finance Act, 2020, every investor is exempt from paying dividend income taxes. The taxation of dividends from mutual funds has undergone a change in April 2020. Here’s a breakdown of the old and new rules:

Pre-April 2020:

• Dividend Distribution Tax (DDT): Mutual funds paid DDT on the dividends they distributed to investors.
• Investors Received Net Amount: Investors received a net dividend amount after the DDT deduction. They didn’t need to pay any additional tax on this amount.

Current System (as of April 2024):

• DDT Abolished: The Dividend Distribution Tax (DDT) has been abolished.
• Tax on Equity Fund Dividends:
  • Dividends from Equity Funds are now subject to Tax Deducted at Source (TDS) if the total dividend payout to an investor in a financial year exceeds ₹5,000.
  • The current TDS rate on Equity Fund dividends is 10%.
  • Investors can claim the deducted TDS amount while filing their income tax returns.

Taxation of Capital Gains Provided by Mutual Funds

It is very crucial to understand how capital gains from mutual funds are taxed. There are two major components that affect the tax rate applied to your mutual funds – type and holding period. The holding period is the time duration an investor holds the mutual fund units. Here is a list of tax treatment performed based on holding period and type of fund:

The following classifies apply to capital gains:

Taxation of Capital Gains Provided by Equity Funds

Profits earned when you sell your Equity Fund units for more than the purchase price are considered capital gains. These gains are taxed differently depending on how long you hold the units (holding period).

Holding Period and Tax Treatment:

• Short-Term Capital Gains (STCG):
  • Applies if you hold the units for less than 1 year.
  • Taxed at a flat rate of 15%, regardless of your income tax slab rate.
• Long-Term Capital Gains (LTCG):
  • Applies if you hold the units for over 1 year.
    • Offers a significant tax advantage:Up to Rs. 1 lakh of LTCG is exempt from tax per financial year. This exemption can be very beneficial for long-term investors.
    • Any amount exceeding Rs. 1 lakh is taxed at 10% (without indexation benefit). This is a lower tax rate compared to STCG.

Taxation of Capital Gains Provided by Debt Funds

Similar to equity funds, profits earned after selling the debt funds units are also considered capital gains. However, unlike Equity Funds, the holding period for Debt Funds is 3 years to qualify for long-term capital gains benefits.

Holding Period and Tax Treatment:

• Short-Term Capital Gains (STCG):
  • Applies if you hold the units for less than 3 years.
  • Taxed as per your income tax slab rate. This can be significantly higher than the LTCG tax rate for Equity Funds, especially for investors in higher tax brackets.
• Long-Term Capital Gains (LTCG):
  • Applies if you hold the units for over 3 years.
  • No longer offers any tax exemption benefit like the previous structure.
  • The lump sum amount will be taxed as per your income tax slab rate (without indexation benefit). This means the tax liability can be higher compared to the previous LTCG regime for Debt Funds.

Taxation of Capital Gains Provided by Hybrid Funds

Hybrid funds, whether it is debt-based or equity-focused, sets how the mutual funds are taxed. Hybrid funds with a focus on debt primarily invest in debt instruments, while those with more than 65% of their portfolio in equity are considered equity-focused schemes.

Here’s a breakdown of taxation as of May 10, 2024:

Equity-Oriented Hybrid Funds:

• Short-Term Capital Gains (STCG): Held less than 1 year – taxed at 15% flat rate.
• Long-Term Capital Gains (LTCG): Held over 1 year:
  • Up to Rs. 1 lakh exempt.
  • Exceeding amount taxed at 10% (no indexation).

Debt-Oriented Hybrid Funds (as of April 2023):

• Short-Term Capital Gains (STCG): Held less than 3 years – taxed as per your income tax slab rate.
• Long-Term Capital Gains (LTCG): Held over 3 years – taxed as per your income tax slab rate (no LTCG exemption or indexation benefit).

Securities Transaction Tax or STT

The Securities Transaction Tax (STT) is a separate tax released by the Indian government on buying and selling of specified securities. Here’s a quick rundown:

• Purpose: Generate revenue for the government.
• Tax Rate: Varies depending on the type of security and transaction (buy/sell).
  • Applicability:Applies to Equity Funds and Equity-Oriented Hybrid Funds (0.001% on transaction value).
  • NOT applicable to Debt Funds or Debt-Oriented Hybrid Funds.

Conclusion

Mutual funds are an exciting investment option, grabbing the attention of most investors these days. However, understanding the tax implications is crucial to know what your true income is. When an investor sells their units after or before the maturity, the capital gain will be exempted to tax, as per the tax income slab and the mutual fund guidelines. Remember, tax laws can change, so consulting a tax advisor for personalised guidance is always recommended. By considering these factors, you can make informed investment decisions and potentially maximise your returns from mutual funds.

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