Tax on Mutual Funds - How Does Taxation on Mutual Funds Work?

 

Albert Einstein once said, “The hardest thing in the world to understand is Income Tax.” 

Mutual funds are another potentially challenging concept to understand. When you combine the two - Income Tax and Mutual Funds - you get a befuddling concoction of rates and terms that may leave you feeling completely befuddled. While this is natural, it isn't the most pleasant sensation. So, let's take a look at how mutual fund taxation actually works.

Tax Fundamentals

According to Indian Income Tax laws, your earnings will fall under one or more of the following five income categories:

• Salary Earnings
• House Property Income
• Profits and Gains from a Trade or Profession
• Gains on Capital
• Other Sources of Income

Each type of income has its own rules governing how it is taxed.

We are concerned with the fourth and fifth income categories for mutual funds, "Capital Gains" and "Income from Other Sources."

What is Tax on Mutual Funds?

Profits from mutual fund investments are taxed in the same way that profits from other asset classes are. So, before investing in mutual funds, ensure you understand how your returns will be taxed. Learning about mutual fund taxation will help you plan your investments to save on your total tax outlay. Furthermore, you may be eligible for tax breaks in certain circumstances. So, while investing in mutual funds, keep in mind the tax rules for mutual funds. 

How do we earn income from Mutual Funds?

Mutual funds provide income to investors in two ways: dividends and capital gains.

When a company makes a profit or has excess cash, it may distribute it to its shareholders as a dividend. Dividends are paid in proportion to the number of mutual fund units we own.

A capital gain is a profit investors make when the selling price of the units exceeds the purchase price. Simply put, when we redeem (sell) some mutual fund units, capital gains result from the appreciation in the cost of the mutual fund units.

Regulations Regarding Mutual Funds Taxation 

Dividend

You can choose between Dividend and Growth plans when investing in mutual funds. If you choose the former option, the dividend you receive will be taxed as "Income from Other Sources." This income, along with any savings bank account or fixed deposit interest you may have, is taxed at the applicable slab rate. It's pretty simple.

Gains on Capital

This is where the majority of the misunderstanding about mutual fund taxation arises. Capital gains on mutual fund unit redemption are taxed based on two factors:

• The mutual fund's asset class (equity, debt, or hybrid).
• The length of time that one has kept the fund (a.k.a. Holding Period, in simple words – the period between the date of purchase and date of sale of the units)

Equity Funds

Short-term capital gains are taxed at a flat 15% rate, regardless of overall income. Long-term capital gains are tax-free, up to $10,000. Long-term capital gains are taxed at a rate of 10% above this.

Note: A 0.001% Securities Transaction Tax (STT) is applied only at the time of redemption of Equity Funds and does not need to be paid separately.

Debt Funds

Short-term capital gains are taxed at your standard slab rate. Long-term capital gains are taxed at 20%, with indexation. Indexation is a method of accounting for inflation from the time of purchase to the time of sale.

Hybrid Funds

If the equity exposure in a hybrid fund exceeds 65%, it is considered an equity fund. Otherwise, they are considered debt funds. As previously explained, taxation rules apply.

Like, Retweet & Comment on what you would like!

Stay updated on news and development related to Web3, personal finance, blockchain development and monetising your skills.

➡️ Subscribe to the newsletter: Nest Aide