Mutual Fund Taxation: Know How Your Mutual Fund Returns Are Taxed

We all invest to get income on our investments in the form of Dividend or capital gains. And if there is income, there’s a tax. The tax on mutual fund investments depends upon the type of fund you’ve invested and how much time you hold it.

Here is what you ought to know about the taxation of Mutual Fund returns, especially Capital Gains Tax and tax on dividend income.

Taxation of Mutual Fund Capital Gains

Capital gain is the profit you make when you sell any investment including Mutual Funds. So if you invested Rs. 50,000 in a fund and it grew to Rs. 75,000 when you redeemed, Rs. 25,000 is the capital gain

The current Mutual Fund taxation rules divide capital gains into two different buckets, based on the duration in which these were generated — Long term Capital Gains (LTCG) and Short Term capital gains (STCG).

The definition of what duration is long term and short term and how much you will pay in taxes on redemption of Mutual Fund units is based on the fund type you invested in.

Now, let’s have a look at how capital gains are taxed for each category.

Capital Gains Tax Rules for Equity Mutual Funds

Long Term Capital Gain Tax

Any capital gains from Equity Mutual Funds held for over 12 months are treated as Long term capital gains and you have to pay 10% tax if those capital gains exceed 1 lakh in a financial year. Even then you pay 10% on the amount which is in excess of the Rs. 1 lakh limit

To understand it better, let’s take an example:

For instance: Mr. Raju invested Rs 50,000 on 1st Jan 2018 and when he redeemed on 1 Feb 2019, he received Rs. 75,000 as redemption value. Now his capital gain is Rs. 25,000 however as he stayed invested for at least 12 months and the gains didn’t exceed Rs. 1 lakh, he doesn’t need to pay any tax on the returns from the Debt Fund.

Now suppose he stayed invested for 4 years and redeemed when his investment value was Rs. 1,75,000. The capital gains on his investment are Rs. 1, 25,000 and he has to pay 10% on the amount exceeding Rs. 1 lakh. So the Capital Gains Tax he needs to pay will be just Rs. 2500 (10% of Rs. 25,000).

Short-Term Capital Gains Tax

If you sell your investment in equity funds within 12 months, the gains on selling them are treated as short-term capital gains (STCG) and taxed at 15 percent.

Here is an example.

Mr. Sharma invested Rs. 35,000 in an Equity Mutual Fund on 25 April 2020 and received Rs. 50,000 upon redeeming the investment on 22 Feb 2021.

Since the investment was held for less than 1 year, Rs. 15,000 generated as capital gains will be treated as short-term capital gain. So, he has to pay capital gains tax at 15% on Rs 15,000, that would be Rs. 2,250 plus health and education cess.

Capital Gains Tax Rules for Debt Mutual Funds

Short-Term Capital Gains Tax

Any gains realized from Debt Mutual Funds are treated as short term capital gain if the investment is sold within 36 months (3 years). These gains are added to your income and the tax on Mutual Fund returns depends on the income tax slab you fall in.

For instance, Sanjeev is in the 30% income tax bracket and he invested Rs 2 lakhs in a debt fund. After two years, he redeemed his investment for Rs. 2.5 lakhs. Since the fund units were held for less than 36 months (3 years), gains realized from the redemption will be treated as Short Term Capital Gains. So, he will have to pay Rs. 15,000 (30% of Rs. 50,000) as capital gains tax on the Debt Fund returns.

Long-Term Capital Gains Tax

Gains realized from debt mutual funds are treated as Long term capital gains if investments are held for more than 36 months. The long term capital gain is taxed at 20% after providing the indexation benefits on cost.

Indexation helps you to adjust the purchase price of a debt fund in order to reflect the impact of inflation on it. This adjustment increases your purchase price and therefore reduces your taxable capital gains. This means that you have to pay less tax on Debt Mutual Fund redemptions if you stay invested for 3 years or longer before redeeming.

For example, suppose Sanjeev invested Rs. 2 lakh in a Debt Fund in FY 2015-16 and stayed invested till FY 2020-2021. Then in FY 2020-2021, he redeemed his investment for Rs 2.5 lakh. Since he has stayed invested for over 3 years, his gains from the scheme will be considered as long-term gains, and the capital gains tax rate of 20% with indexation benefit will be applicable.

The below table shows how long-term capital gains tax on Debt Funds is calculated:

Tax on Dividend Income from Mutual Funds

Apart from capital appreciation, another way you can earn returns from Mutual Funds is through dividends. If you opt for the dividend plan of a Mutual Fund, the scheme will share the profits generated with you.

Dividends from both Equity and Debt Mutual Funds are taxable in the hands of the investor. Mutual Fund dividends are taxed as per the tax slab of the investor. So, investors in the 30% tax bracket will have to pay 30% tax on the dividends received.

Now that you know all about Mutual Fund taxation, with some planning, you can minimize the taxes you need to pay on your returns.