Tax on Mutual Funds - How Mutual Funds are Taxed? (2024)

Mutual Funds are typically regarded as one of the most profitable investment options because they help you easily reach your financial objectives. The fact that MFs are tax-efficient investment vehicles is one of their most significant benefits. Your investment in a Mutual Fund may yield tax-efficient returns. However, without considering tax, you might be investing in Mutual Funds incorrectly.

Because it will impact your cash flow, an investor should consider other factors in addition to taxation, such as taxation on dividends, redemption, etc. In addition, planning your investments to reduce your overall tax expense can be facilitated by understanding the taxation of Mutual Funds.

This blog will walk you through every aspect of Taxation on Mutual Funds.

Taxation on Mutual Funds

Knowing how your Mutual Fund returns will be taxed is crucial if you currently invest in Mutual Funds or plan to do so in the future. Mutual Fund gains and profits are taxable, just like those from the majority of the other asset classes you invest in. Understanding the tax on Mutual Funds rules before you start investing will be beneficial because taxes are difficult to avoid.

You can plan your investments to reduce your overall tax expense by becoming knowledgeable about the taxation of Mutual Funds. In some circumstances, you can also take advantage of tax deductions. So, while investing in it, stay informed of the tax on Mutual Funds regulations.

Variables Determining the Taxation for Mutual Funds

The principles of Mutual Fund taxation are much simpler to understand when they are further broken down into smaller pieces.

So let us start by taking a look at the 4 variables that affect the tax liability of Mutual Funds:

1) Types of Funds

Mutual Funds are divided into two groups for tax purposes: Equity-Oriented Mutual Funds and Debt-Oriented Mutual Funds.

2) Capital Gains

When you sell a capital asset for more money than it costs to purchase, you make a profit, known as a Capital Gain.

3) Dividend

A dividend is a portion of accumulated profits that the Mutual Fund house distributes to the scheme's investors; investors do not need to sell their assets to receive a dividend.

4) Holding Period

The tax you will pay on your capital gains depends on the Holding Period. Therefore, less tax will be due if your Holding Period is longer. Because India's income tax laws encourage longer holding times, keeping your investment longer lowers your tax burden.

How Do Mutual Funds Generate Profits?

Mutual Fund investing allows investors to profit from either Capital Gains or Dividend Income. Let us define them and examine their differences in more detail.

Profit from selling an asset for more than its cost is known as a Capital Gain. However, it is crucial to remember that Capital Gains are only realized upon redeeming the Mutual Fund units. As a result, the Capital Gains Tax on Mutual Funds only becomes due at redemption. Therefore, the tax on Mutual Funds redemption must be paid when the upcoming fiscal year's income tax returns are submitted.

Another way for investors in Mutual Funds to receive income from a fund is through Dividends. Based on its accumulated distributable surplus, the Mutual Fund declares Dividends.

When paid to investors, Dividends are distributed at the fund's discretion and immediately subject to taxation. Therefore, when investors receive a Dividend from their Mutual Funds, they must pay tax on it. The following section contains information on the previous and current Mutual Fund dividend tax regulations.

- Taxation of Dividends Provided by Mutual Funds

The Finance Act of 2020 made a change that eliminated the Dividend Distribution Tax. Investors were exempt from paying taxes on dividend income from Mutual Funds until March 31, 2020.

Dividend Distribution Tax (DDT) was deducted by the fund houses that announced dividends before paying them to the Mutual Fund investors. The investor must pay taxes on the entire dividend income according to the income tax bracket under the heading "Income from Other Sources."

The Mutual Fund scheme's dividend is also subject to TDS (tax deducted at source). The AMC is now required to deduct 10% TDS under Section 194K from the dividend that the Mutual Fund distributes to its investors when the rules have changed if the total dividend paid to an investor during a financial year exceeds ₹5,000. You can claim the 10% TDS that the AMC has already taken out when you pay your taxes and only pay the remaining amount.

- Taxation of Capital Gains Provided by Mutual Funds

The holding period and type of Mutual Funds affect the tax rate on capital gains for Mutual Funds. The holding period is the length of time an investor held units of a Mutual Fund. Put simply, the holding period is the time between the date of buying and selling Mutual Funds units.

The following categories apply to capital gains realized on the sale of Mutual Fund units-

Type of Mutual Fund

Holding Period on STCG

Holding Period on LTCG

Equity Funds

Less Than 12 Months

More Than 12 Months

Debt Funds (Until 31st March 2023)

Less Than 36 Months

More Than 36 Months

Hybrid Fund-Equity Oriented

Less Than 12 Months

More Than 12 Months

Hybrid Fund-Debt Oriented (Until 31st March 2023)

Less Than 36 Months

More Than 36 Months

- Taxation of Capital Gains Provided by Equity Funds

Mutual Funds classified as equity funds have an equity exposure of at least 65%. As previously stated, when you redeem your equity fund units within a holding period of one year, you realize short-term capital gains.

Regardless of your income tax bracket, these gains are taxed at a flat rate of 15%. When you sell your equity fund units after holding them for at least a year, you realize long-term capital gains. These capital gains are tax-free, up to Rs 1 lakh per year.

Any long-term capital gains over this threshold are subject to a 10% LTCG tax, with no benefit of indexation.

- Taxation of Capital Gains Provided by Debt Funds

Debt mutual fundshave entirely different taxation. If a debt investment is sold within 3 years until March 31st 2023, it will be deemed as STCG. This STCG will be added to the income of the investor and would be liable to be taxed according to the tax slab under which the investor falls.

If debt investments' holding period is more than 3 years, it will be termed as LTCG. It will attract an LTCG tax of 20% with indexation benefits.

Note indexation is applicable to only LTCG that's earned on non-equity-oriented mutual funds.

Another important thing to note is that the fund manager will levy an STT of 0.001% if you plan to sell your equity fund units. STT is not applicable to the sale of units in debt funds.

It is essential to remember that debt funds no longer have the benefit of LTCG. The capital gains that arise from such funds will be liable to be taxed according to the tax slab rate under which an investor falls in.

- Taxation of Capital Gains Provided by Hybrid Funds

Whether a Hybrid Fund is equity-focused or debt-focused determines how the Mutual Fund taxes it. All other hybrid funds are debt-focused, while those with equity exposure over 65% are considered equity-focused schemes.

Depending on how much equity exposure they have, hybrid funds may or may not be subject to the same tax regulations as Equity or Debt Funds.

- Securities Transaction Tax or STT

The Securities Transaction Tax is separate from the Capital Gains and Dividend Taxes. When you buy or sell Mutual Fund units of an Equity Fund or a Hybrid Equity-Oriented Fund, the government (Ministry of Finance) will assess an STT of 0.001%. On the other hand, the sale of Debt Fund units is exempt from STT.

Conclusion

In conclusion, investors can learn how Mutual Funds are taxed if they are concerned that their returns from Mutual Funds will be reduced after paying taxes. They can determine what is advantageous for them by calculating how the tax rules for long- and short-term investments in equity and debt funds differ.

By investing in tax-saver funds, they can reduce their tax obligations and corpus generation. Taxation for a type of fund is the same whether it is purchased in a lump sum or through a SIP (Systematic Investment Plan). However, long-term investments may be more tax-efficient than holding the units for a brief period.

Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.

Tax on Mutual Funds - How Mutual Funds are Taxed? (2024)

FAQs

Tax on Mutual Funds - How Mutual Funds are Taxed? ›

Mutual fund taxes

How are you taxed on mutual funds? ›

Short-term capital gains (assets held 12 months or less) are taxed at your ordinary income tax rate, whereas long-term capital gains (assets held for more than 12 months) are currently subject to federal capital gains tax at a rate of up to 20%.

How is tax calculated on mutual fund income? ›

The income in the form of dividends from mutual funds (now called IDCW) will be taxed as 'Income from Other Sources' as per your income tax slab rate. If the dividend amount is above Rs 5,000 dividend will be subject to TDS as per Section 194K @10% for resident individuals, but if the PAN is not provided then @20%.

How to avoid capital gains tax on mutual funds? ›

Hold Funds in a Retirement Account

This means you can sell shares of your mutual fund or collect a capital gains distribution without paying the relevant taxes so long as you keep the money in that retirement account. You will ultimately owe any related taxes once you withdraw the money, of course.

How are mutual funds tax-efficient? ›

Tax-Efficiency Factor: Dividends

While this may be a convenient source of regular income, the benefit may be outweighed by the increase in your tax bill. Most dividends are considered ordinary income and are subject to your normal tax rate. Mutual funds that do not pay dividends are thus naturally more tax-efficient.

Are mutual funds always taxable? ›

Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain." But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares.

Are mutual funds taxed as income or capital gains? ›

Capital gains distributions are paid by mutual funds from their net realized long-term capital gains and are taxed as long-term capital gains regardless of how long you have owned the shares in the mutual fund. Mutual funds may keep some of their long-term capital gains and pay taxes on those undistributed amounts.

How much mutual fund is tax free? ›

You are allowed to invest up to Rs 1.5 lakh in tax-saving funds. You will get a tax deduction of up to Rs 1.5 lakh under Section 80C of the Income Tax Act. a.

What is the tax on long term mutual funds? ›

Debt mutual funds are used to invest in debt instruments from the market. The long term capital gain tax rate on mutual funds is 20% after indexation, which adjusts the acquisition cost for inflation using the Cost Inflation Index (CII).

How do you declare income from mutual funds? ›

Dividend Income - Whether the dividend is received from a debt mutual fund or an equity mutual fund, it is considered as the investor's income and added to his total income under the head income from other sources. A salaried individual can disclose such income in ITR-1 under 'Income from other sources. '

Are mutual funds taxed twice? ›

Mutual funds are not taxed twice. However, some investors may mistakenly pay taxes twice on some distributions. For example, if a mutual fund reinvests dividends into the fund, an investor still needs to pay taxes on those dividends.

Can I switch mutual funds without paying taxes? ›

If you switch from an equity fund before one year, you will have to pay short-term capital gains tax at 15%. If you switch after one year, you will have to pay long-term capital gains tax at 10% on the gains exceeding Rs. 1 lakh in a financial year.

Is it good when a mutual fund gets really big? ›

Funds that have a long track record of good performance tend to get large as more and more investor money flows into them, and this money gets a long time to grow. They were good, so they eventually became large.

What are the tax disadvantages of mutual funds? ›

Mutual fund taxes
  • Dividends and interest: If the fund holds securities that pay dividends or interest, the fund will distribute your share of those payments to you, and you'll owe taxes on that income. ...
  • Capital gains: The fund manager may sell securities in the fund for a profit, triggering a capital gains tax.
Mar 27, 2024

Why are mutual funds bad in a taxable account? ›

When looking at the 10 largest mutual funds by asset size, the turnover ratio is almost 75% (1). This means investors will pay higher taxes in the form of distributions due to mutual fund managers selling or buying 75% of the stocks that make up their fund annually.

Which mutual funds are most tax-efficient? ›

Top Tax-Efficient Mutual Funds for U.S. Equity Exposure
  • Vanguard Total Stock Market Index VTSAX.
  • Vanguard 500 Index VFIAX.
  • DFA US Core Equity 1 DFEOX.
  • iShares S&P 500 Index WFSPX.

Do you pay taxes twice on mutual funds? ›

Mutual funds are not taxed twice. However, some investors may mistakenly pay taxes twice on some distributions. For example, if a mutual fund reinvests dividends into the fund, an investor still needs to pay taxes on those dividends.

Are mutual fund dividends taxable if reinvested? ›

If the company pays out cash dividends, you will owe taxes on those payments even if you decide to reinvest the cash received. If however, the company reinvests your dividends to purchase additional shares, you will not owe taxes until you sell those shares.

What happens if I sell mutual funds at a loss? ›

If you sell a mutual fund investment and the proceeds are less than your adjusted cost base, you realize a capital loss. Most capital losses can be applied against capital gains to reduce the amount of taxes payable.

Do you pay taxes on investments if you don't sell? ›

Some taxes are due only when you sell investments at a profit, while other taxes are due when your investments pay you a distribution. One of the benefits of retirement and college accounts—like IRAs and 529 accounts — is that the tax treatment of the money you earn is a little different.

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