Taxation in MF: Tax charged on SWP, IDCW & Growth Fund redemption, and Tax savings opportunities

Let us say you invest Rs 1 lakh in a mutual fund. It grows to Rs 2.5 lakh in X years. You decided to sell your holdings and make a nice profit of Rs 1,50,000. However, your net profit will not be fifty thousand. You need to pay the taxes. How much goes to the taxes depends on two points:

• What kind of mutual fund did you hold?
• What was the holding period?

As an investor, you must understand the tax implications before investing in any mutual fund. It will help you determine your absolute returns. In this article, we cover different mutual funds options, and how taxation works for them. In the end, we share a tip to save tax on your mutual fund profits.

Systematic Withdrawal Plan: Mutual Fund Taxation

Let us first understand the Sytematic Withdrawal Plan (SWP). SWP is a feature offered by mutual funds that allows you to withdraw a predetermined amount of money from your investment at regular intervals. SWP is particularly useful if you look to generate a regular income stream from your mutual fund investments while keeping the investment intact.

The taxation of SWP mutual funds will depend on the category. For example, if you have invested in an equity mutual fund, the taxation rules similar to equity will apply. What are the rules?

Equity Mutual Fund: SWP Example

The gains on your investments if withdrawn in the first year are treated as Short Term Capital Gains (STCG) and taxed at 15%. If the investment is redeemed after the first year, the gains are called Long Term Capital Gains (LTCG) and are taxed at 10%. Let us understand how it will work out in SWP.

Let us say you invest Rs 5 lakh in a mutual fund on 1st January 2024 and set up a SWP plan to withdraw Rs 10,000 monthly. For simplicity, let us assume that NAV was Rs 100, so you got 5000 units. On the 1st of February, the market increased by 10% (highly unlikely, but an assumption for easy understanding). The value of your NAV increased to 110. For 10,000 income, approximately 91 units are sold. 

Your gain in this first can be calculated as below (approx values):

• Initial Investement in 91 units: Rs 9,100
• Withdrawal Value of 91 units: Rs 10,000  
• Capital Gain: Rs 900

Since the withdrawal happened within a year, you need to pay a 15% tax on the amount, which comes to be Rs 135. 

If the market had corrected by 10% in the same period, there would be losses. Let us say that NAV came down to Rs 95 per unit at the end of the first month. In this case, the AMC needs to sell 105 units to give you Rs 10,000.

• Initial Investment in 105 units: Rs 10500
• Withdrawal Value of 105 units: Rs 10,000 
• Capital Loss: Rs 500

You can offset these losses with gains. You can offset short-term capital loss against long- and short-term capital gains. The calculation will continue similarly. After one year, the tax will be reduced to 10%. 

In a financial year, your net gains will be calculated, and you pay tax on it. In the case of LTCG, if the total gain is less than Rs 1 lakh, you don't need to pay any tax.

Debt Fund Mutual: SWP Example

If you have invested in a debt mutual fund and opted for SWP. The gain/loss will be calculated as mentioned above. The net gains get added to your income and taxed as per your tax slab.

IDCW Mutual Fund: Taxation

DCW stands for Income Distribution cum Capital Withdrawal. It refers to a type of dividend option offered by the mutual fund, where the fund periodically distributes a part of its income (dividend) to the investors, and if there are any capital gains, they are distributed as well. The tax treatment of IDCW depends on the nature of the income being distributed. For example, dividends from equity-oriented mutual funds were subject to Dividend Distribution Tax (DDT) until it was abolished in the Finance Act 2020.

After the abolition of DDT, dividends are now taxable in the hands of the investors at their respective income tax slabs. So, these funds are not beneficial for investors who fall in the 20 or 30% tax slab.

Growth Plan: Taxation

The growth plans of mutual funds are taxed similar to what we have discussed in the SWP option. Here, you are not making regular withdrawals. If you withdraw within the first year, you pay STCG at 15%. After one year, the gains are taxed at 10% for gains over Rs 1 lakh.

Ways to Save Tax: Tax Loss Harvesting

Tax loss harvesting is a strategy used by investors to offset capital gains by selling investments that have incurred losses. This allows investors to minimize their tax liability by using the losses to offset taxable gains. Here's an example using a hypothetical mutual fund investment:

Let us say you invested in a mutual fund and bought 1,000 units at Rs. 100 per unit, resulting in a total investment of Rs 100,000.

Now, the market value of the mutual fund has decreased, and the current unit price is Rs. 80. The current market value of your investment is:

• Market Value: 1,000 units at Rs 80 = Rs 80,000

In this scenario, if you sell your units, you will incur a loss of Rs 20,000 

Now, you have another investment in a different mutual fund that has gained Rs 20,000 during the same period.

• Purchase: 1,000 units at Rs. 50 = Rs 50,000
• Market Value: 1,000 units at Rs. 70 = Rs 70,000

In this case, you have a capital gain of Rs 20,000 

Now, to offset the capital gains, you decide to sell the units from the first fund that have incurred a loss. By selling the units at a loss, you can use that loss to offset the capital gain and reduce your overall tax liability. In this case, your net tax liability becomes zero.

Before you go

We hope you learned something new about mutual fund taxation through this article. Be it mutual funds or any other investment, it is essential that you calculate returns post-tax for comparison and your absolute returns. It will help you plan your goals more effectively.