Tax On Mutual Fund Investment

Different Types of Income Tax on Mutual Funds

In general, mutual funds are classified as debt funds, equity funds, and hybrid funds. In order to have a clear picture of your mutual fund gains or returns, it is very important to know what type of tax, and how much tax you're going to pay on your returns. 

Being said that there are different types of tax  on mutual funds:

1. Capital Gain Tax on Mutual Funds

When you sell your mutual fund assets at some profit, the total amount earned is known as the capital gain. For those who don't know, capital is the principal amount you've invested to purchase mutual funds of your choice. Let's understand this with the help of an example:

Suppose you've purchased a couple of MF units for Rs. 1000. In this case, your capital or principal amount is Rs. 1000. Now, if this investment generated a return of 10%, then the value of your investment becomes Rs. 1100. So, here Rs. 100 is the capital gain. 

Capital Gain = Total Income - Initial Investment 

In the above example, the amount of Rs. 100 will be taxed. 

Note that, you have to pay the capital gain tax only at the time you're selling your asset. Thus, if you choose to stay invested for a longer duration, you'll not have to pay capital gains tax. 

2. Tax on Equity Mutual Funds

When equity investments are sold before one year, then the MF returns come under short term capital gains (STCG). These are generally subjected to a tax value of 15%. Further, if the investments are sold after the completion of one year, then the gains come under long term capital gains (LTCG). It is important to note that the LTCG worth up to Rs. 1 lakh is tax-free. However, for gains above 1 lakh, you'll have to pay a tax of 10%.

Another equity scheme that needs to be mentioned here is the Equity Linked Saving Scheme (ELSS funds). It is one of the most efficient schemes that serve great tax-saving benefits. These mutual funds come with a lock-in period of 3 years. You can claim deductions of up to Rs 1.5 lakh for your investment in ELSS funds.

3. Tax on Debt Mutual Funds 

Tax on debt mutual funds is completely different from equity funds taxation. 

Generally, if you sell your debt investments before the completion of three years, they will be categorized as short term capital gains. This STCG is then added to your income and will be taxed accordingly. Further, the debt funds sold after 3 years are considered as LTCGs and are subjected to a tax value of 20% plus indexation benefits. 

The indexation benefits are what make debt mutual funds attractive to the investors looking for investment options with better tax benefits. 

Simply put, indexation helps in minimising tax as it increases the purchase cost. It is done by adjusting capital gains to the CII (Cost Inflation Index). Moreover, keep in mind that indexation can only be done on non-equity oriented MFs. 

4. Tax on Dividend Income

If you invest in a mutual fund scheme with a dividend option, you will receive regular payouts in the name of dividends. 

Whenever such a mutual fund scheme makes a profit, that profit is evenly distributed among its investors in the form of dividends. 

Notably, the finance ministry of India has changed the mutual fund dividend tax rules in the Union Budget 2020. Now, the fund houses don't need to pay DDT (Dividend Distribution Tax) on equity as well as debt mutual funds. 

Before the DDT was scrapped in India, the debt mutual funds were taxed as follows:

DDT = 12% on the base rate (+4% cess) + surcharge rate

From 1st April 2020, MF dividends are taxed in investors' hands on the basis of their income tax slab rate. This was brought into practice to lower the burden on small investors. With the new regulations, dividend income is now treated as regular income and is taxable in the hands of investors at their tax slab rate. 

Moreover, dividends worth more than Rs. 5,000 are subjected to a TDS (Tax Deducted at  Source) value of 10%. And this value becomes 20% in case your PAN is not linked to your Aadhar card. 

How Do You Earn Returns from Mutual Funds?

When you invest in a mutual fund, your returns primarily come from three sources:

• Capital appreciation: If the value of the fund’s underlying assets (like shares or bonds) rises, the Net Asset Value (NAV) of your units increases. You realise these gains when you sell or redeem your units.
• Dividends: Many funds earn income from dividends on stocks or interest from bonds. This income may be paid out to investors or reinvested in the fund, depending on the option you choose.
• Capital gains distribution: If the fund sells holdings at a profit, it may distribute these gains to investors.

Choosing a growth option means returns are reinvested and compound within the fund. Choosing a dividend option provides periodic payouts but may affect NAV differently. Remember that fund expenses and transaction costs reduce your net returns.

Taxation of Dividends Offered by Mutual Funds

Dividends from mutual funds are now taxable in the hands of investors. The Dividend Distribution Tax (DDT) was abolished in 2020, and tax is charged as part of your income. Here’s what you need to know:

• TDS deduction: Asset managers deduct tax at source (TDS) under Section 194K if annual dividends exceed ₹10,000 per fund house (effective from 1 April 2025).
• Filing and credit: TDS can be claimed as a tax credit when filing your return.
• Non-resident investors: NRIs and those without PAN may face different TDS rates.
• Compliance: Forms 15G/15H and DTAA rules may apply, so it’s best to consult a tax professional for clarity.

This ensures dividends are taxed correctly while you stay compliant with current regulations.
 

Factors Determining Mutual Fund Taxation in India

There are two key factors that determine the taxation of mutual funds in India. One is the type of mutual fund, and the other is the tenure of investment. Let's discuss both of them in detail:

1. Type of Mutual Fund Scheme

How much income tax you need to pay on your mutual fund gains depends largely on the type of mutual fund scheme. We have already mentioned that mutual funds are broadly classified as equity and debt funds. 

Talking about equity mutual funds, these funds invest in equity stocks and shares available in the stock market. Because they are subjected to high market volatility, they carry a higher level of risk. Further, the equity funds are again classified as large-cap, small-cap and mid-cap mutual funds. 

On the other hand, debt funds mostly invest in safer places such as corporate bonds, government bonds and policies, etc. These options are low in risk and offer fixed returns. Moreover, debt funds are categorized as liquidity funds, income funds, and short-duration funds. 

2. Duration of Your Investment

Your holding period or the tenure of your investment also plays an important role in determining the income tax on your mutual fund scheme. The holding period can be either long term or short term. 

In the case of equity funds, a holding period of less than one year or 12 months is known as short-term. And any investment that continues for over a year comes under the long term. 

Similarly, in the case of debt funds, a holding period of less than 3 years is known as short term and tenure over 3 years is considered long-term.

Final Words

Understanding how mutual funds are taxed is very important for every investor. However, it can get a bit intimidating for beginners. But if you continue to invest and learn, you will get a clearer picture in mind and you'll be able to make better investments. 

Just make sure to read and understand an investment product completely before investing in it. This will make sure that you don't have to pay unnecessary expenses in the form of tax liabilities and exit loads. Moreover, you can always make use of online tools such as SIP calculators and income tax calculators to calculate your returns and taxation of mutual funds. We hope this information helps you. For more information on mutual fund taxation, visit 5Paisa!