Albert Einstein once said, “The hardest thing in the world to understand is Income Tax.” Another possibly hard thing to understand is Mutual Funds. Now, when you combine the two – Income Tax and Mutual Funds – what you get is a baffling concoction of rates and terms that might leave you feeling totally clueless. While this is natural, it isn’t the greatest feeling. So, let’s take a look at how taxation on mutual funds really works.
The Basics
According to Indian Income Tax laws, your earnings will fall under one or more of these five heads of income:
- Income from Salary
- Income from House Property
- Profits & Gains from Business or Profession
- Capital Gains
- Income from Other Sources
Each head of income has rules pertaining to how the income is taxed.
For mutual funds, we are concerned with the fourth and fifth heads of income, “Capital Gains” and “Income from Other Sources”.
How do we earn income from Mutual Funds?
Mutual funds offer investors returns (income) in two forms; dividends and capital gains.
When a company earns a profit or has surplus cash, it may decide to pay this out to us investors as dividend. We receive dividends in proportion to the number of mutual fund units we hold.
A capital gain is the profit realised by investors if the selling price of the units is greater than the purchase price. In simple terms, when we redeem (sell) some units of a mutual fund, capital gains arise due to the appreciation in the price of the mutual fund units.
Both these forms of income, dividends and capital gains, are taxable. Dividends are taxed under the head, “Income from Other Sources”, and Capital Gains, as the name suggests, are taxed under the head, “Capital Gains”.
The Taxation Rules
Dividend
When you invest in mutual funds, you have an option to pick between the Dividend Plan and the Growth Plan. If you’ve opted for the former, the dividend that you receive will be taxed under the head, “Income from Other Sources”. This income, along with any savings bank account interest and fixed deposit interest that you might have, is taxed at the slab rate applicable to you. Pretty straightforward.
Capital Gains
This is where most of the confusion about mutual fund taxation arises. Capital gains on redemption of mutual fund units is taxed based on two factors:
- The type of mutual fund (Equity / Debt / Hybrid)
- The duration that one has held on to the fund (a.k.a. Holding Period, in simple words – the time period between the date of purchase and date of sale of the units)
Equity Funds
Short-term capital gains are taxed at a flat rate of 15%, irrespective of overall income. Long-term capital gains are exempt upto ₹1,00,000. Beyond this, long-term capital gains are taxed at 10%.
Note: A Securities Transaction Tax (STT) rate of 0.001% is applied at the time of redemption of Equity Funds only and need not be paid separately.
Debt Funds
Short-term capital gains are taxed at the normal slab rate applicable to you. Long-term capital gains are taxed at 20% with the benefit of indexation. Indexation is a method of taking inflation into account, from the time of purchase to the time of sale.
Hybrid Funds
Hybrid funds are treated as equity funds if the equity exposure is greater than 65%. Else they are treated as debt funds. Taxation rules are then applicable as explained above.
Planning Your Redemptions
Investors tend to redeem mutual fund investments whenever they are in need of money. This could lead to high capital gains in a particular financial year. Since ₹1 lakh of long term capital gains from equity investments (including stocks and mutual funds) are tax-free for each financial year, one could redeem investments in a planned manner. For instance, one could redeem some units in March, which is the end of the previous financial year, and the remaining units in April, which marks the beginning of a new financial year, so that you are able to claim the ₹1 lakh exemption each in two financial years.
It is pertinent to note that when redeeming only some and not all units of a scheme, the FIFO rule applies. This simply means that the earliest investment will be redeemed first.
All in all, the universe of mutual funds and taxation can be quite intriguing. If this is an area that you’d like to explore further, be sure to enroll for A Beginner’s Guide to Mutual Funds. Our team will take you through the nuances and guide you through the process of forming an investment strategy for yourself.
