Mutual funds are among the favourite investment options for many retail investors in India. They are known for the benefits of diversification and their tax-friendly investment options that could provide greater returns than fixed deposits, especially if you come under the highest income tax bracket. When the interest you earn is fully taxed, the remaining 5.3% to 6.3% returns would not be so significant considering the inflation rate in India.
So, how does income tax on mutual funds in India work? And is there an income tax on mutual fund redemption? Actually, there are two ways in which mutual funds provide returns to their investors — capital gain and dividends. And for both, the tax treatment is different.
Taxation on dividend
According to the Union Budget 2020 amendments, dividends earned by investors would be added to their taxable income and taxed according to their income tax slab rates.
Earlier, dividends were tax-free with respect to the investors as the companies were paying the DDT or the dividend distribution tax before sharing these dividend profits. During this period, investors were exempted from tax on dividends received from domestic companies up to Rs. 10 lakh per year. However, a DDT of 10% was applied to any dividends exceeding Rs. 10 lakh in a financial year.
Taxation on capital gains
The taxation on a capital gain depends on the mutual fund plan type and its holding period. For an equity fund or a hybrid-equity oriented fund, if investors hold the mutual fund unit for more than a year, it is categorised as Long-Term Capital Gain (LTCG), and if these units are sold before 12 months, then it comes under Short-Term Capital Gain (STCG).
For a debt fund or a hybrid-debt oriented fund, if investors hold the mutual fund unit for more than three years, it is categorised as Long-Term Capital Gain (LTCG), and if these units are sold before 36 months, then it is a Short-Term Capital Gain (STCG).
The following table contains the data of how these types are taxed concerning their holding period.
| Equity funds or hybrid equity-oriented funds | Debt funds or hybrid debt-oriented funds
|
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| Short-term capital gains
|
15% + cess + surcharge | Taxed at the investor’s income tax slab rate |
| Long-term capital gains | Tax-exempt up to Rs. 1 lakh per year. Gains above Rs. 1 lakh are taxed at 10% plus cess + surcharge | 20% + cess + surcharge |
Equity-Linked Savings Schemes (ELSS) are the only type of mutual funds that come with a tax deduction benefit under the Income Tax Act, 1961. You can claim a deduction of up to Rs. 1.5 lakh per year under section 80C. It’s a great tax-saving instrument and has a lock-in period of three years, the lowest among all tax-saving schemes.
If you have more doubts about mutual fund types, schemes, and types of funds to invest in, you can consult a financial advisor to guide you through your investment options and help you fulfil your financial goals.
Mutual funds are surely a great investment option for experienced investors and traders who intend to diversify their portfolio as well as for the newer comers looking to start their investment journey. Your mutual fund units will become more tax-efficient the longer you keep them; this would increase the chance of higher returns as the market’s primary nature is to go up.
