When you are investing, it is always important to consider the tax implications of the particular investment to understand how tax efficient the returns could be. Mutual funds are considered to be tax efficient investment options. Tax treatment and tax implication varies depending on the category of mutual funds you are investing into. You can take a detailed look at the taxation aspect of mutual funds below –

Taxation of mutual fund based on the type of fund

1) Tax implications for Equity mutual funds

Equity mutual funds are the funds that invest primarily in equities of companies. Any fund that invests more than 65% into equities is considered as an equity mutual fund for taxation purposes. Tax treatment for equity oriented hybrid funds that invests more than 65% into equities would be similar to that of equity funds.

If you make profit by redeeming your equity mutual fund investments, it is referred to as capital gains which are subjected to income tax. Following is the tax treatment for capital gains from equity mutual funds –

  • Short-term capital gains

Gains from equity mutual funds are classified as short-term if the units sold are held for less than one year. Short term capital gains are taxed at 15% plus cess.

  • Long-term capital gains

Gains from equity mutual funds are classified as long-term if the units sold are held for one year or more. Long-term capital gains have been reintroduced (which were tax free till April 2018) in the unit budget 2018. Presently, long-term capital gains on equity funds are taxed at 10% without indexation, only if the annual gain from equity exceeds INR 1 lakh.

2) Tax implications for ELSS (Equity Linked Savings Schemes)

Equity linked savings schemes (ELSS) are the type of equity mutual funds that come with taxation benefits. ELSS funds are designed to provide tax benefits as it comes with a three years lock-in period. Which means, you cannot exit from the fund within three years of investment. But, you can avail tax deduction of up to INR 1.5 lakhs under Section 80C of the Income Tax, 1961. However, tax treatment of capital gains from ELSS schemes is similar to that of equity mutual funds.

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3) Tax implications for debt mutual funds

Debt mutual funds are funds that invest predominantly into debt securities. Debt-oriented hybrid funds that allocate significant proportion into debt securities are also treated similar to that of debt funds for the taxation purpose.
If you make profit by redeeming your debt mutual fund investments, it is referred to as capital gains which are subjected to income tax. Following is the tax treatment for capital gains from debt mutual funds –

  • Short-term capital gains

Gains from debt mutual funds are classified as short-term if the units sold are held for less than 36 months or three years. Short-term capital gains from debt funds are taxed as per tax slab applicable to you based on your total taxable income.

  • Long-term capital gains

Gains from debt mutual funds are classified as long-term if the units sold are held for three years or more. Long-term capital gains on debt mutual funds are taxed at 10% without indexation and at 20% with indexation benefit.

Fund of funds, exchange traded funds and international mutual funds are also treated similar to debt mutual funds for the purpose of taxation. Tax implications are similar to that of debt funds for all of these funds.

4) Tax implications on mutual fund dividends

Dividends received on mutual fund investments are taxed differently depending on the type of fund. Dividends paid by the mutual funds are subjected to dividend distribution tax (DDT) which is paid by the mutual fund companies. Mutual fund companies pay DDT of 11.648% on equity funds and 29.12% on debt mutual funds. Dividends were tax free in the hands of investors.

However, there is a major change in dividend distribution tax rule as introduced in the Union Budget 2020. In the new tax regime, dividend on mutual funds will be taxed as per the tax slab applicable to you depending on your total taxable income. Dividend on mutual funds needs to be now added to taxable income under the header ‘Income from other sources’.

Here is a step-by-step process to invest mutual funds in India.

Taxation is an important aspect of your financial planning. Understanding the tax implication on mutual fund schemes that are planning to invest can help you make effective investment decisions. Understanding the mutual funds, its working, types, routes and process to invest in along with the tax implications on each type of mutual funds can give you a general idea about the product as a whole.

When you are making an investment decision, understanding the product helps you make an informed and rational choice that would lead you towards your financial goal.

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