Mutual funds are one of the most buzzing investment options as they help you achieve your financial goals. Mutual funds are also tax-efficient instruments. Investing in fixed deposits is a great disadvantage, particularly if you fall under the highest income tax bracket, as the interest is added to your taxable income and taxed at your income tax slab rate. This is where mutual funds score better. When you invest in a mutual fund, you get the benefit of expert money management and tax-efficient returns.
How Do You Earn Returns in Mutual Funds?
Mutual funds offer investors returns in two forms; dividends and capital gains. Dividends are paid out of the profits of the company if any. When the companies are left with surplus cash, they may decide to share the same with investors in the form of dividends. Investors receive dividends proportional to the number of mutual fund units held by them.
A capital gain is the profit realised by investors if the selling price of the security held by them is greater than the purchase price. In simple terms, capital gains are realised due to the appreciation in the price of the mutual fund units. Both dividends and capital gains are taxable in the hands of investors of mutual funds.
Taxation of Capital Gains Offered by Mutual Funds
The taxation rate of capital gains of mutual funds depends on the holding period and type of mutual fund. The holding period is the duration for which the mutual fund units were held by an investor. In simple words, the holding period is the time between the date of the purchase and sale of mutual fund units. The short-term and long-term capital gains offered by mutual funds are taxed at different rates.
Taxation of Capital Gains of Equity Funds
Equity funds are those mutual funds whose portfolio’s equity exposure exceeds 65%. As mentioned above, you realise short-term capital gains on redeeming your equity fund units within a holding period of one year. These gains are taxed at a flat rate of 15%, irrespective of your income tax bracket.
You make long-term capital gains on selling your equity fund units after a holding period of one year or more. These capital gains of up to Rs. 1 lakh a year are tax-exempt. Any long-term capital gains exceeding this limit attracts LTCG tax at the rate of 10%, and there is no benefit of indexation provided.
Taxation of Capital Gains of Debt Funds
Debt funds are those mutual funds whose portfolio’s debt exposure is in excess of 65%. As mentioned in the table above, you get short-term capital gains on redeeming your debt funds units within a holding period of three years. These gains are added to your taxable income and taxed at your income tax slab rate.
Long-term capital gains are realised when you sell units of a debt fund after a holding period of three years. These gains are taxed at a flat rate of 20% after indexation. Also, you are levied with applicable cess and surcharge on tax.
Taxation of Capital Gains of Hybrid Fund
The rate of taxation of capital gains on hybrid or balanced funds is dependent on the equity exposure of the portfolio. If the equity exposure exceeds 65%, then the fund scheme is taxed like an equity fund, if not then the rules of taxation of debt funds apply.
Therefore, it is essential to know the equity exposure of the hybrid scheme you are investing in, if not then you might be in for a nasty surprise on redemption of your fund units.
Taxation of Capital Gains When Invested Through SIPs
Systematic investment plans (SIPs) are a method of investing in mutual funds. They are designed in such a way that investors can invest a small amount periodically in a mutual fund scheme. Investors are offered the liberty to choose the frequency of their investment. It can be weekly, monthly, quarterly, bi-annually, or annually.
You purchase a certain number of mutual fund units through every SIP instalment. The redemption of these units is processed on a first-in-first-out basis. Suppose you invest in an equity fund through an SIP for one year, and you decide to redeem your entire investment after 13 months.
In this case, the units purchased first through the SIP are held for the long-term (over one year) and you realise long-term capital gains on these units. If the long-term capital gains are less than Rs 1 lakh, then you don’t have to pay any tax.
However, you make short-term capital gains on the units purchased through the SIPs from the second month onwards. These gains are taxed at a flat rate of 15% irrespective of your income tax slab. You will have to pay the applicable cess and surcharge on it.
Conclusion
The longer you hold on to your mutual fund units, the more tax-efficient they become. The tax on long-term capital gains is comparatively lower than the tax on short-term gains.
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