Taxation on mutual funds in India
Three key things determine the tax on mutual funds in India.
- Are you investing in equity or non-equity funds?
- How long are you holding the units for?
- How much capital gain did you make on redemption?
When you get these variables right, you can easily calculate your tax on mutual funds.
Before finding out your tax obligation, it’s important to know how mutual funds are classified for tax purposes in the first place.
How are equity mutual funds taxed in India?
As per SEBI regulations, equity mutual funds need to invest a minimum of 65% of their portfolio in domestic equity shares. Based on the holding period, your taxation can be categorised into two buckets.
Short-term capital gains (STCG)
If you sell the mutual fund units within 12 months of investing in the fund, a 20% STCG applies on equity-oriented mutual funds. The tax gets triggered the moment you redeem within that 12-month window, regardless of how large or small the gain is.
Long-term capital gains (LTCG)
LTCG applies if you’ve held your mutual fund units for more than 12 months. Currently, a 12.5% LTCG applies to your mutual fund gains.
There’s a silver lining, though. Gains up to ₹1.25 lakh in a financial year are fully exempt from LTCG tax. That means only the amount that exceeds this threshold gets taxed at 12.5%.
It’s the gap between 20% and 12.5% that long-term investing pays off. Staying invested longer softens your tax bill. It also lets compounding work harder for you.
How are non-equity mutual funds taxed?
This includes debt funds and hybrid funds with less than 65% exposure to equities. The rulebook for taxation is very different for these asset types.
The LTCG-vs-STCG distinction does not apply to gains from debt mutual funds. Regardless of the tenure through which you hold the units, the gains are considered short-term. The new rules have come into force since 1st April 2023.
They are added straight to your total income, and taxed at the applicable tax rate. There’s no indexation benefit either. That’s the inflation-adjustment perk debt funds used to enjoy earlier.
If you're holding older debt fund units bought before April 1, 2023, the rules are again different. Those funds can qualify for concessional long-term treatment if you hold them for more than 3 years. Your purchase date is worth checking carefully before you assume which rule applies to you.
And then there are hybrid funds, sitting in between. If the equity exposure of these funds exceeds 65%, they’re treated like mutual funds while being taxed. Below that, follow the debt fund rulebook.
Now, you might be wondering why the tax rate for non-equity mutual funds varies so much. The decision comes down to how these instruments are viewed.
Equities are treated as growth-and-risk-oriented assets. Debt is considered closer to fixed income. That’s why debt mutual funds are taxed on the basis of your tax slab, just like regular income.
What happens when you receive dividends?
In case you had opted for the dividend (IDCW) option instead of growth, that payout counts as taxable income in your hands.
It is taxed at your regular income slab rate. This rule has been in place since the Dividend Distribution Tax was scrapped in Budget 2020. You also have TDS to think about. As per Section 194K, fund houses deduct 10% TDS in case your dividend from a single AMC exceeds ₹5,000 in a financial year.
This isn’t an extra tax. The amount is deducted upfront, but you can claim it back or get it adjusted when you file your income tax returns.
Factors that affect mutual fund taxation
Now, there are a few variables that decide your final tax bill.
Holding period
This has the highest impact. Just cross the 12-month mark on equity funds, and your tax rate drops from 20% to 12.5%. Also, you benefit from the exemption.
Type of mutual fund
As discussed above, the logic behind taxing equity and non-equity mutual funds is completely different.
Capital gains amount
Bigger gains mean more tax. That’s obvious. But you can still benefit from the ₹1.25 lakh exemption on equity LTCG. Small, disciplined gains can slip through tax-free entirely.
Your tax slab
Your overall taxable income matters, too. Non-equity funds are taxed at your slab rate. So, someone in the 30% bracket will pay a very different amount compared to someone in the lower bracket on gains from the same debt fund.
How to invest to maximise tax efficiency?
A few habits genuinely move the needle. Stay invested for the long haul. The gap between STCG and LTCG alone can fetch you profits. Avoid redeeming your mutual fund units just because you have the option.
Unnecessary churn triggers tax that could have been avoided in the first place. Each year, plan your withdrawals around your ₹1.25 lakh exemption window instead of redeeming all the units in one shot.
Maintain clean records of purchase dates and amounts. This is particularly important for SIPs as each instalment has its own holding period.
Under the old tax regime, there’s a provision of claiming a deduction up to ₹1.5 lakh under Section 80C for ELSS funds. If you are eligible, you may check out that benefit.
When you choose a mutual fund, always consider your post-tax return.
Common misconceptions about mutual fund taxation
Well, there are a few myths that refuse to fade away.
- Firstly, mutual funds are not tax-free. Every gain you make, and every dividend you get, comes with some tax implications.
- Tax generally gets triggered only when you redeem your units or get a dividend payout. Not during the phase when your money remains invested.
- A fund with higher returns doesn’t mean higher post-tax gains automatically. A high-turnover fund may lose more to STCG compared to one with steadier long-term holding.
- Income from dividends isn’t tax-free. They are taxed at your slab rate.
Conclusion
Tax on mutual funds isn’t too complicated once you get the logic behind how tax is levied. Just evaluate the concept based on the type of fund and your holding period. Equity funds reward patience with lower long-term capital gains tax and an annual exemption.
Tax on non-equity funds is based on your decisions. It’s important to understand the tax hit before you redeem your units.
