Mutual funds investments are one of the most transparent and fantastic investments as it has numerous options available that are broadly categorized between debt and equity. Mutual funds are like an ocean with all possible schemes linked to your financial goals. They can help you achieve your goals by investing in a disciplined manner and continuously monitoring them.
It is easy to understand mutual fund taxation by understanding which category they fall in, whether equity or debt.
And once you can recognize whether it is equity or a debt mutual fund, you need to apply a simple rule to understand Mutual Fund Taxation for that particular scheme.
Table of Contents
Mutual Fund Category Viz Mutual Fund Scheme
A mutual fund is a vehicle that pools money from various investors and invests based on the scheme objective. If you are investing in a mutual funds scheme, then it is a must for you to understand its objective, and if your objective of investment matches with the scheme objective, then only should you invest in that particular scheme.
Let’s understand the difference between Mutual Funds Category and Mutual Fund Scheme with an example:
| Mutual Fund AMC | Mutual Fund Category | Mutual Fund Scheme | Mutual Fund Scheme Objective |
| Axis Mutual Fund | Equity | Axis Bluechip Fund | To achieve long-term capital appreciation by investing in a diversified portfolio predominantly consisting of equity and equity-related securities of Large Cap companies, including derivatives. However, there can be no assurance that the scheme’s investment objective will be achieved. |
| Axis Mutual Fund | Equity | Axis Mid Cap Fund | To achieve long-term capital appreciation by investing predominantly in equity & equity-related instruments of mid-size companies. The fund’s focus would be to invest in relatively larger companies within this category. |
| Axis Mutual Fund | Equity | Axis Arbitrage Fund | To generate income through low volatility absolute return strategies that take advantage of opportunities in the cash and the derivative segments of the equity markets, including the arbitrage opportunities available within the derivative segment, by using other derivative-based strategies and by investing the balance in debt and money market instruments. However, there is no assurance or guarantee that the scheme’s investment objective will be achieved. The Scheme does not assure or guarantee any returns. |
| Axis Mutual Fund | Debt | Axis Short Term Debt Fund | To generate stable returns with a low-risk strategy while maintaining liquidity through a debt and money market instruments portfolio. However, there can be no assurance that the scheme’s investment objective will be achieved. |
When is Mutual Fund Taxation applies to you?
You, as an investor, can earn Mutual Funds Return in two ways- Dividend & capital gain.
Mutual Fund Taxation applies to investors only when they realize return either in dividends or as a capital gain by selling/redeeming mutual fund units.
As mentioned earlier, mutual fund taxation depends upon the investment category they fall in along with the investment time horizon.
Mutual Fund Taxation of Capital Gains
Mutual fund capital gain tax is applicable only when the gain is realized by selling the units. For any notional capital gain, tax is not applicable.
Let us understand this with an example:
Suppose you have invested Rs. 1 lakh in a mutual fund scheme in 2016, and now the market value of that investment is Rs. 2 lakhs, that means a notional capital gain of Rs. 1 lakh – Will you have to pay tax on this?
The answer is NO- no mutual fund taxation will be applicable unless you sell the units and realize your capital gain of Rs. 1 lakh.
Suppose you decide to sell 50% of your investment, which is Rs. 1 lakh out of Rs. 2 lakhs; in that case, your notional capital gain is Rs. 50,000, whose value may further increase in the future and on this notional capital gain of Rs. 50,000, there won’t be any capital gain tax applicable. However, on the other half 50,000 realized capital gain, mutual fund taxation will be applicable based on which category they fall in equity or debt.
💡Pro Tip: Learn How to Invest in direct mutual funds and earn up to 1% extra returns
Mutual Fund Taxation of Dividend
Mutual Fund Taxation of Dividend payout was earlier taxed in the hands of the company. However, in the Union Budget 2020, dividends offered by any mutual fund scheme are taxed based on the investor’s income tax slab. Hence, you will find the dividend paid out detailed in the Form 26AS, which was not seen earlier.
Note: Investors option for dividend reinvested option in mutual funds do not receive dividend and fund manager use the dividend to buy additional units of the same scheme. Hence, taxation in the dividend reinvestment option is applicable only at the time of realized capital gain.
Taxation of Capital Gains of Equity Funds and Debt Funds
Taxation of Capital Gains of Equity and Debt Funds are based on its duration:
| Fund Catagory | Short Term Capital Gain (STCG) | Long Term Capital Gain (LTCG) |
| Equity | Less than 12 months | More than & equal to 12 months |
| Debt | Less than 36 months | More than & equal to 36 months |
Any mutual fund scheme holding 65% of equity or more is considered under equity fund, and if otherwise, then debt fund for taxation.
💡Pro Tip: Equity Arbitrage fund, which is a low-risk scheme, is considered under an equity scheme for taxation due to arbitraging in equity. Instead of liquid funds, you may park your emergency fund to generate a better post-tax return.
Taxation of Capital Gains of Hybrid Funds
Hybrid mutual funds are those funds whose portfolio is a mix of equity and debt.
Taxation of Capital Gains of Hybrid Fund depends upon percentage mix of equity or debt where equity portion 65% or more is considered as equity and debt portion 65% or more is considered debt fund.
| Fund Catagory | Short Term Capital Gain (STCG) | Long Term Capital Gain (LTCG) |
| Hybrid equity-oriented funds | Less than 12 months | More than & equal to 12 months |
| Hybrid debt-oriented funds | Less than 36 months | More than & equal to 36 months |
| Arbitrage Fund | Less than 12 months | More than & equal to 12 months |
Therefore it is a must to know what is the fund category. Now, as you know how to recognize the type of mutual funds, let’s understand exactly how much tax you will pay on your capital gain.
| Fund Catagory | Short Term Capital Gain (STCG) | Long Term Capital Gain (LTCG) |
| Equity Funds | 15% of Capital gain | Capital gain up to Rs 1 lakh every financial year is tax-free. Any gains above Rs 1 lakh are taxed at 10% |
| Debt Funds | Capital gain taxed at the investor’s income tax slab rate | 20% of Capital gain |
| Hybrid equity-oriented funds | 15% of Capital gain | Capital gain up to Rs 1 lakh every financial year is tax-free. Any gains above Rs 1 lakh are taxed at 10% |
| Hybrid debt-oriented funds | Capital gain taxed at the investor’s income tax slab rate | 20% of Capital gain |
| Arbitrage Fund | 15% of Capital gain | Capital gain up to Rs 1 lakh every financial year is tax-free. Any gains above Rs 1 lakh are taxed at 10% |
How Mutual Funds Are Taxed When Invested Through SIP?
A systematic investment plan (SIP) in a mutual fund is the best way to invest in a disciplined manner. A systematic investment plan permits you to invest in small chunks and start with as little as Rs. 500 per month investment.
💡Pro Tip: For a mutual fund scheme to qualify for Long Term Capital Gain (LTCG), each SIP transaction should complete 12 months or more in the case of equity-oriented mutual fund and 36 months or more in the case of debt funds. Hence, for the tax benefit, quarterly SIP in ELSS makes more sense than monthly for easy redemption.
Example:
Suppose you opt for monthly SIP in ELSS for three years and want to redeem the entire amount together, then you will have to wait for six years in total as your last transaction needs to complete three years. So, first transition six years.
However, if you plan your investment based on financial planning then the monthly investment is preferable.
SIP has the power of creating wealth in the long run; this reminds me of a famous proverb, “a small drop of water makes an ocean.”
Here is the link to the SIP calculator; play with the number and check how much wealth you can create with Rs. 500 investment per month.
Securities Transaction Tax (STT)
Securities Transaction Tax is applicable only regarding the sale of units of Equity-oriented funds on a recognized stock exchange and sale (redemption / switch-out/ STP Out) of units of Equity Oriented mutual funds by the mutual fund.
STT in mutual funds does not apply to any other schemes purchase/ sale/ redemption of units.
Note: In Mutual Funds, switch & STP are also considered the sale. In case of a switch from one equity scheme to another, the scheme will attract STT, and capital gain tax will also be applicable.
Securities Transaction Tax (STT) applicable towards units equity-oriented mutual fund Schemes:
| Transaction | Rates | Payable by |
| Purchase of units of equity-oriented mutual fund | Nil | Not Applicable |
| Sale of units of an equity-oriented mutual fund (delivery based) | 0.001% | Seller |
| Sale of units of an equity-oriented mutual fund (non-delivery based) | 0.025% | Seller |
| Sale of units of an equity-oriented fund to the Mutual Fund | 0.001% | Seller |
Conclusion
Mutual Funds Equity Oriented Mutual funds are best suited for long-term goals. Do not invest in it without assessing your risk appetitive and just by looking at its return. Plan your redemptions for the best post-tax return.
