Taxation is considered to be one of the most difficult subjects to understand. However, we have made it easier for you to understand the tax element of mutual funds in this article.

To understand mutual fund taxation, we must first understand how you generate money from mutual funds. As a mutual fund investor, you can earn money in two ways: dividends and capital gains. Dividends are a regular source of income provided by mutual funds from the earnings of your investments. Dividends are paid to mutual fund investors in proportion to the number of units they hold.

Capital gain, on the other hand, is the profit made by mutual fund investors when they sell or redeem their mutual fund shares. For example, if you invested Rs 10,000 and the value at the time of sale is Rs 20,000, your capital gain is Rs 10,000 (Rs 20,000 minus Rs 10,000). However, it is important to point out that only the profits made are accounted for for tax purposes. Additionally, dividends and capital gains are also taxable in the hands of mutual fund investors.

Dividends and taxation

Payments were previously tax-free in the hands of investors since mutual funds paid dividend distribution tax (DDT) before paying out dividends to investors. However, dividends paid by any mutual fund are taxed in the hands of mutual fund investors, in line with the revisions established in the Union Budget 2020. This means that dividends received by investors must be included in their aggregate income and taxed on the applicable income. rate of the tax slab.

Capital gains taxation

Long-term capital gains and short-term capital gains are two types of capital gains. Therefore, before we can understand how capital gains are taxed, we must first understand how long-term and short-term capital gains are characterized.

The table above clearly shows how different mutual funds define long-term and short-term capital gains. From a tax perspective, mutual funds are divided into two broad types: equity mutual funds and debt mutual funds, where anything less than 12 months is short-term and anything over 12 months is long term for equity mutual funds and anything less than 36 months is short term and anything over 36 months is long term for mutual funds.

However, we have hybrid funds which are a combination of equity and debt. Therefore, in order to establish their long and short term outlook, we need to look at their equity and debt components. If a hybrid fund has at least 65% equity at all times, it is called an equity fund, and if it contains at least 65% debt, it is considered a mutual fund. In addition, the hedge fund, which falls under the hybrid category, is normally taxed like an equity fund unless it holds 65% or more debt securities.

Taxing stock mutual funds

According to the table above, if you sell an equity fund within the first 12 months, it is considered a short-term capital gain and is taxed at 15% plus cess, regardless of your tax bracket. . Also, if you sell a stock fund after one year, profits up to Rs one lakh are tax exempt.

This implies that if your long-term capital gains are less than Rs one lakh, you are not liable to pay tax. However, if they exceed Rs 1 lakh, they will be subject to a tax of more than 10% (without any indexation benefit) on the excess earnings. For example, if your long-term capital gains are Rs 80,000, you do not have to pay tax, but if they are Rs 1,20,000, you have to pay Rs 2,000 tax ( 10% of Rs 1.2 lakh minus Rs 1 lakh).

Taxing Debt Mutual Funds

Referring to the previous table, if you redeem units of debt mutual funds before 36 months, they will be considered short-term capital gains and will be added to your overall income and taxed at your tax rate. on income. However, if you sell debt funds after 36 months, you will be subject to a 20% tax with an indexation benefit.

Indexing is simply the process of adjusting your purchase price to account for inflation. Earnings are determined by subtracting the inflated buy price from the sell price. This minimizes your gain (not practically, but for tax purposes), so you have to pay less tax. The cost inflation index (CII), which is produced each year, is used to calculate it.

SIPs are taxed differently

The Systematic Investment Plan (SIP) is a method of investing in mutual funds that allows participants to invest a modest amount on a regular basis – daily, weekly, monthly, quarterly, semi-annually or annually. With each SIP, you actually acquire a fixed number of units of that fund, and redemption of those units is on a first-in, first-out basis.

For example, if you invest in a mutual fund through a monthly SIP for one year and choose to redeem your entire investment after 13 months, only units acquired through the SIP in the first month are considered long-term, and you realize long-term capital gains on these shares.

If your winnings are less than Rs 1 lakh, you are not liable to pay tax. However, the remaining units have not yet completed the 12 months. You thus generate short-term capital gains on the shares you have acquired. These profits would be taxed at a flat rate of 15% plus cess, regardless of your tax bracket. Similarly, debt funds operate in the same way as equity funds, with the exception of the tax treatment applied to debt funds, which is covered in the section “Taxing Debt Mutual Funds.”