Taxation of Capital Gains from Mutual Funds: Debt Funds, Equity Funds, Hybrid Funds
When you invest in a mutual fund, you can choose between a growth option and a dividend option. Under a growth option, your income from a scheme gets reinvested into the scheme to offer you compounded income. If you avail a dividend option, the income from a scheme gets allocated among the investors at regular intervals.
The income earned from the transfer or sale of a mutual fund scheme is popularly termed capital gains. Keep reading this article to know how such capital gains are taxed!
Returns from Mutual Funds
Mutual funds provide returns in two ways− capital gains and dividends. Capital gains denote profits that investors realise if a security’s selling price is more than its purchase price. It simply means that investors realise such gains when there arises an appreciation in the mutual fund units’ price.
Investors receive dividends when a company in a fund’s portfolio makes profits. When a company realises surplus income, it may distribute the same among the investors by way of dividends. The total number of mutual fund units that an investor holds is in proportion to their dividends.
There are tax implications for investors in the case of both capital gains and dividends.
Capital Gains Tax on Mutual Funds
The type of mutual fund scheme and the holding period determine the taxation on capital gains. A holding period is a tenure for which an investor holds mutual fund units. It denotes the time period between the sale date and the purchase date of such units.
Moving forward, capital gains earned after selling the units of a scheme can be of the following types:
| Type of Fund | Long-term Capital Gains (LTCG) | Short-term Capital Gains (STCG) |
| Debt funds | When the holding period is above 3 years | When holding period is up to 3 years |
| Equity funds | When holding period is above 1 year | When holding period is up to 1 year |
| Debt-based hybrid funds | When holding period is above 3 years | When holding period is up to 3 years |
| Equity-based hybrid funds | When holding period is above 1 year | When holding period is up to 1 year |
The long-term and short-term capital gains on mutual funds are taxable at varying rates.
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Capital Gains Tax on Debt Funds
A debt fund is a mutual fund scheme whose debt exposure is at least 65%. You receive STCG on redeeming the units within 3 years. Such gains are taxable as per your tax slab.
If you sell the units after 3 years, you get LTCG. Such profits are taxable at the rate of 20% after getting indexation benefits. Besides, the IT Department will impose a surcharge and cess on your tax.
Capital Gains Tax on Equity Funds
An equity fund is a mutual fund scheme whose equity exposure is at least 65%. An investor realises STCG on redeeming the units within 1 year. Such gains will be taxable at the rate of 15%, regardless of your tax slab rate.
An investor earns LTCG on selling the units after 1 year. Such profits will be tax-free up to Rs. 1,00,000 per annum. Long term capital gains above this limit are subject to a tax rate of 10% with no indexation benefit.
Capital Gains Tax on Hybrid Funds
A portfolio’s equity exposure determines the capital gains tax rate on hybrid funds. In case the equity exposure is at least 65%, then hybrid funds will be taxed just like equity fund schemes. If not, then hybrid funds are taxed like debt funds.
Hence, you must know about a hybrid fund’s equity exposure before investing. The chart below guides you through the capital gains tax on mutual funds:
Capital Gains Tax while Investing Through an SIP
A SIP (Systematic Investment Plan) is an investment mode in mutual fund schemes. Through it, individuals can invest small amounts in mutual funds periodically. People can select their investment frequency such as annually, half-yearly, quarterly, monthly or weekly.
You can buy a particular number of units of mutual funds via each SIP instalment. A first-in-first-out technique is applicable for processing the redemption of such mutual fund units.
For example, let’s say Mr. Jay Agarwal invests in an equity mutual fund via a systematic investment plan for 1 year. He redeems his investment post 13 months. Here, he has bought the units through an SIP. He will realise LTCG on the units that he purchased in the first month.
If these profits are below Rs. 1 lakh, then there will be no tax implications for him. However, he earns STCG on the equity fund units from the 2nd month onwards. Such profits will be taxable at the rate of 15%, regardless of his tax bracket. Further, he will be paying surcharge and cess.
Tax on Dividends of Mutual Funds
According to the Union Budget 2020, dividends will be taxable in the traditional manner. That means your taxable income will include such dividends and the tax liability will depend on your income tax bracket.
In the past, dividend income was tax-free for investors because the organisations paid DDT (Dividend Distribution Tax) prior to sharing dividends with investors. For this regime, investors didn’t have to pay taxes for dividends (distributed by domestic companies) of up to Rs. 10,00,000. Dividends over Rs. 10,00,000 per fiscal year were subject to DDT @10%.
Tips to Save Capital Gains Tax on Mutual Funds
Follow the tips below to effectively save taxes on your capital gains earned from mutual funds:
1. Go by the Holding Period
Tax on capital gains is incidental in nature and is applicable when you sell your mutual fund units. You can redeem the units at regular intervals making sure that the holding period is more than 1 year to avoid paying STCG tax.
2. Investment in ELSS Funds
As per Section 80C of the IT Act, individuals can get tax deductions of up to Rs. 1,50,000 through investments in Equity Linked Savings Schemes (ELSS). Note that these schemes have a lock-in period of 3 years.
Final Word
People invest in mutual funds to enjoy the benefits in the long run. With an in-depth understanding of tax deductions, you can get the best out of these schemes.
FAQs
Ans: Other than taxes on capital gains and dividends, there exists another kind of tax known as STT (Securities Transaction Tax). When you sell units of a hybrid equity-based fund or an equity fund, the government imposes an STT @0.001%. No STT is applicable for selling debt mutual fund units.
Ans: To compute capital gains on mutual funds, a fund house will require the cost of acquisition and sale value. The cost of acquisition denotes a particular value at which an investor acquires an asset. Sale value refers to the consideration that an investor gets when units are sold or transferred.
Ans: Indexation involves the recalculation of a mutual fund unit’s purchase price after making adjustments for inflation rates. The income tax authorities publish this indicator. As a scheme’s purchase price gets adjusted with the inflation index, your capital gains get minimised. This indexation benefit is applicable to the LTCG earned from non-equity mutual funds.
Ans: A fund house computes short-term capital gains in the following way:
STCG = Value of consideration – Acquisition cost – Improvement cost – Expenses incurred during sale or transfer
Here, sale or improvement cost denotes the amount paid to make additions to an asset or a fund. It also includes the expenditure incurred to make the sale.
Ans: In the case of equity funds, the computation of LTCG and STCG remains the same. For this,
LTCG = Value of Consideration – Acquisition cost – Asset/fund improvement cost – Expenses incurred during sale or transfer
In the case of debt funds, there will be adjustments to the inflation index. The calculation will be as follows:
LTCG = Sale value – Acquisition cost (indexed) – Expenses incurred during the sale.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
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