Taxation in Mutual Funds

Mutual funds are the best investment options if you want to build wealth with minimal risk. However, before you make these investment decisions, you must understand how mutual fund returns are taxed.

Factors influencing mutual funds taxation in India

The taxation of mutual funds relies on the three common factors listed below. 

1. Fund type

A mutual fund scheme primarily allows you to invest in two different kinds of plans. The first is an equity-oriented scheme, and the second is a debt-oriented scheme. The suffix oriented signifies the proportion of the total portfolio invested in equity or debt.

2. Types of mutual gains

Mutual fund earnings are of two types—capital gains and dividend income. The former occurs when you sell your holdings for a higher price than you paid for them. On the other hand, dividend income refers to the part of the profit that an Asset Management Company (AMC) distributes to you and other investors in the specific scheme based on their holdings. To receive a dividend, you must choose the dividend option at the time of investment. 

3. Holding period

The duration till you hold your investment determines the rate at which you will be paying taxes on your investment. Investments that are held longer will have a lower tax liability.

Now that you know the influencing factors, it’s time to go over them one by one to understand mutual fund taxation.

Taxation in Mutual Funds

1. Tax on dividend income

Previously, dividend income was tax-free in the hands of investors. The AMC deducted the Dividend Distribution Tax (DDT) before distributing it to the investors. However, after the amendment in the Finance Act in 2020, you are required to pay taxes on the dividend income. 

The taxation on this type of earning is in accordance with your income tax slab. The dividend income falls under the fifth head of the Income Tax Act, which is ‘Income from other sources.’ In addition, such earnings are subject to tax deducted at sources. According to the new amendment, the AMC shall deduct 10% TDS under section 194K while distributing dividends if the total dividend paid to you is more than Rs. 5,000 in the financial year.

2. Tax on capital gains

Capital gain taxation in mutual funds depends upon your scheme type and the holding period. Below is the table briefing the same. 

• Taxation of equity oriented mutual funds:

Equity oriented funds refer to schemes in which the portfolio’s overall exposure to equity or equity-related securities is equal to or greater than 65%. If you invest in such a plan and redeem your units before 12 months from the date of investment, you will be subject to a 15% flat tax on gains.

If you sell your equity oriented mutual fund unit after holding it for more than a year, you will be subject to LTCG at a 10% rate. Further, you will also not receive any indexation benefits. However, remember that the LTCG of up to Rs 1 lakh is exempt from taxes. 

• Taxation of debt oriented mutual funds:

Debt oriented funds are those scheme in which the portfolio’s overall exposure to debt or debt-related products is equal to or more than 65%. You will have to pay STCG tax if you sell your debt scheme units before the completion of 36 months. The gains will be clubbed to your taxable income, and the tax rate will be determined by your income tax slab.

LTCG tax will apply on your gains if you redeem your debt fund holding after 36 months. The tax rate will be 20% after considering indexation. In addition, you need to pay applicable surcharge on tax. Indexation benefit allows you to adjust your capital gain with inflation. 

 3. Securities Transaction Tax (STT)

In addition to capital gains and dividend income, you will have to pay an STT of 0.001% on selling of equity oriented mutual funds.

To conclude

The rate of taxation of mutual funds relies on your holding period and whether you have invested in debt or equity funds. The taxes imposed on the LTCG are comparatively lower than STCG.

Disclaimer: ICICI Securities Ltd. (I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Venture House, Appasaheb Marathe Marg, Prabhadevi, Mumbai - 400 025, India, Tel No : 022 - 6807 7100. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein above are solely for informational purpose and may not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments or any other product. Investments in securities market are subject to market risks, read all the related documents carefully before investing. The contents herein mentioned are solely for informational and educational purpose.