Understanding taxes on mutual funds

A mutual fund is an investment vehicle where many investors pool their money to invest collectively in securities, stocks or bonds.

The total market value of assets under a scheme of a mutual fund is called as Asset Under Management (AUM) and such fund is managed by a fund manager.

As per the data published by the Association of Mutual Funds in India (AMFI), the total AUM of the mutual fund industry as of September 2021 stood at over Rs 36 lakh crore.

Primarily, mutual funds attract such huge investments due to two reasons: it is expected to earn higher returns based on historical trends and the returns are taxed at lower rates.

Let’s understand the returns and the taxes applicable on mutual funds.

One can get two types of returns from mutual fund investments: dividends and capital gains. Dividends are paid out of the profits of the company whereas capital gain is the profit earned on selling the mutual fund units.

Both are taxable in the hands of the investors. Dividends are taxable as Income from Other Sources at the applicable income tax slab rates.

Those who are not in need of immediate cash flow can opt for a Growth Option than a Dividend option while choosing the scheme.

The capital gains are taxable based on the period of holding and the type of mutual fund. A mutual fund can be an equity fund or a debt fund.

Equity funds are those funds whose investment in equity shares exceed 65%. If the holding period of such funds is less than 12 months, it is considered as Short Term and the gains you realise from redeeming them are taxed at a flat rate of 15%, irrespective of the tax slabs.

If the period of holding equity funds is over 12 months, it is classified as long-term assets and gains from the sale of such funds are taxed at 10%, with a tax-exempt threshold limit of Rs 1 lakh.

Usually, while computing the capital gains, one can consider indexation but such benefit is not available for the sale of mutual funds.

Hybrid funds or balanced funds that have over 65% exposure to equities are also considered at par with equity funds for tax purposes.

Debt funds invest over 65% of the portfolio in securities that generate fixed income like bonds, government securities, etc. To classify debt funds as short-term, the period of holding should be less than 36 months.

The short-term capital gains on the sale of debt funds are taxed at the taxpayer’s income tax slab rates, whereas the long-term gains are taxed at a flat rate of 20% after indexation. The hybrid or balanced funds that have exposure of over 65% to debts get the same tax treatment as pure debt funds.

Remember, all tax rates have to be increased by surcharge and cess, as applicable.

You would have heard of a familiar term called ‘Systematic Investment Plan’ (SIP) method of investing in mutual funds. SIP means purchasing the units of mutual funds at regular intervals, say monthly, quarterly, etc. In case of redemption, the units are processed on a first in first out (FIFO) basis. The same rules for the period of holding apply here as well, based on equity or debt fund.

There are more innovative products under mutual funds, such as funds investing in stocks abroad or fund of funds that invest through various mutual funds.

All these are considered like debt funds for tax purposes. Another point to note is that a mutual fund has two types of plans, regular and direct. The expense ratio of direct plans is lower than regular plans.

If an investor wants to switch from a regular plan to a direct, it is considered as redemption and applicable taxes have to be paid on switching the plan.

A popular tax saving instrument u/s 80C of Income Tax Act, Equity Linked Savings Scheme (ELSS) is an equity fund and taxed accordingly.

The past trend suggests that the investors who stay invested long in mutual fund instruments have earned higher returns when compared to investments in fixed deposits or other traditional savings instruments.

(The author is a chartered accountant and registered valuer)