Investing in mutual funds is the best way to hit your financial goals. But that’s not the only good thing about it. Mutual funds are also a tax-efficient instrument compared to other forms of investing. When you invest in mutual funds, you get the benefits of both expert money management and tax-efficient returns. So, before we get into the taxation of mutual funds, let us get a better explanation of mutual funds.
What are mutual funds?
Mutual funds are an investment tool that combines large sums of money from different mutual fund investors in a single pot. The investor’s money is then used to invest in different financial securities such as bonds, stocks, gold, shares, and others. Moreover, mutual funds are run by professionals who allocate the investor’s money. This, in turn, generates revenue and or capital gain. With this, the stakeholder also has an equal role to play when it comes to the profits and losses endured by the stock. But that’s not all; you can also take a loan against your mutual funds, where you can use your mutual fund as collateral to get a loan. Whether you get the loan approved depends on the loan against mutual funds eligibility.
What is a tax on mutual funds?
When you earn profits from investing in the most beneficial mutual fund in India, that profit is called ‘capital gains.’ These capital gains are taxed, so before you start your mutual funds investment journey, you have to have a clear understanding of how your returns will be taxed and where you can avail of tax deductions.
What are the factors that determine the tax on mutual funds?
In order to understand how your mutual funds will be taxed, you need to know the factors that influence it. Here is a list of factors that affect the taxes levied on mutual funds:
- Fund types: Mutual funds and taxation rules vary based on the type of mutual fund. Examples include equity mutual funds, debt mutual funds, Hybrid mutual funds, and more.
- Capital gains: Capital gains are the profit the investor earns when they sell their capital asset at a higher rate than its total investment amount.
- Holding period: The period between the date of purchase and sale of the mutual funds unit is called the holding period. As per the income tax regulation of India, if you hold your investment for an extended period, then you are liable to pay a low tax amount. Thus, the holding period influences the tax that you will pay on your capital gains. The higher the holding period, the lesser the tax you have to pay.
- Dividend: A dividend is the part of the profit that is distributed among investors by mutual fund houses; this is called a Dividend
Let’s take a look at how each influences the tax levied on your mutual funds.
Taxation of mutual fund’s capital gains:
The tax levied on the capital gains depends on the mutual fund’s holding period and the type of mutual funds. Let’s take a look at how these factors affect the taxation on mutual fund’s capital gain:
| Short term Capital Gains | Long term capital gains | |||
| Type of mutual fund | Pre-budget 2024 | Post budget 2024 | Pre-budget 2024 | Post budget 2024 |
| Indian Equity Funds/ETFs & Equity-oriented hybrids | 15% (if holding period is less than a year) | 20% (if holding period is less than a year) | 10% (on capital gains above Rs 1 lakh if held for over 1 year) | 12.5% (on gains above Rs 1.25 lakh if held for over 1 year) |
| Debt funds/ETF & debt-oriented hybrids* | Slab rate | Slab rate | Slab rate | Slab rate |
| All FOFs (that hold less than 65% in debt)/International/gold funds/ETFs** | Slab rate | if holding period is less than 2 years | Slab rate | 12.5% if holding period is less than 2 years |
Taxation on dividends earned from mutual funds
The Finance Act of 2020 scrapped the Dividend Distribution Tax (DDT), meaning investors now have to pay taxes on dividends from Mutual Funds themselves. Earlier, fund houses would deduct the tax before giving out dividends, but now investors must report the full amount as “Income from Other Sources” and pay tax based on their income bracket. Mutual fund dividends also have a 10% tax Deduction at source (TDS) rule. If the total dividends paid to an investor go over Rs.5,000 in a financial year, the Asset Management Company (AMC) will deduct 10% TDS upfront. When filing taxes, investors can claim the TDS already deducted and pay the remaining tax based on their tax slab. This shift makes dividend income taxable directly to the investor instead of at the fund level.
In conclusion, mutual funds offer expert management and tax efficiency, making them a strong investment choice. Understanding the types of funds, capital gains, holding periods, and dividend taxation is crucial for maximising returns and minimising taxes. Understand mutual funds and taxes properly and plan wisely to optimise your financial gains from mutual fund investments.