Tax Calculation on Mutual Funds
One of the questions that many mutual fund investors have in their mind is about the taxation of returns from their investment. While some wonder if they can get tax deductions from their investments, others ponder if they should pay tax on their mutual funds.
The returns that you earn from mutual funds are taxed under ‘Income from Capital Gains’. The captain gains can be short term or long term based on how long you hold investments. The term period (short term or long-term) can also differ among equity and non-equity mutual funds. Let us delve into the taxation aspect of mutual funds in a detailed yet simplistic manner –
- Taxation for Equity Mutual Funds
A mutual fund scheme qualifies as an equity scheme if it has an investment of at least 65 percent of total corpus in equity and equity-related instruments. If the investments are held for 1 year or less, the returns are taxed as short-term capital gains, at 15 percent (plus applicable surcharge and education cess). If the investments are held for more than a year, the returns are considered as long term capital gains; these returns are completely exempt from income tax. In other words, you do not pay any tax on equity mutual funds that you redeem after 1 year.
- Taxation of Debt Mutual Funds
A mutual fund scheme that invests less than 65 percent of the corpus in equity is categorized as non-equity mutual funds, for taxation purposes. Debt mutual funds, gold funds, fund of funds, etc. fall in the category of non-equity schemes.
If the non-equity funds are held for three years or less, the returns are taxed as tax on short-term capital gains. These gains are added to the individual’s income and taxed per the applicable income tax rate. The highest tax rate is 30 percent of the capital gains (plus applicable surcharge and education cess). Capital gains taxes are not deducted from the fund house at source, while redemption; investors have to pay it themselves.
The returns from non-equity funds are considered as ‘long term capital gains’ if the investments are held for more than three years. The returns are taxed at 20 percent (plus applicable surcharge and education cess) after indexation. Indexation is a procedure that makes use of the cost inflation index to inflate the purchase price. The process of indexation shrinks taxable profits.
Most people tend to invest their money in an FD, assuming it is a good tool for investment.
According to the Income Tax Act of 1960, interest income from FDs is added to an individual’s total income and is taxed according to one’s tax slab irrespective of the investment tenure, making it a very tax inefficient product. Debt funds and FDs are taxed similarly between 1 and 3 years. But post 3 years, for a debt fund, a flat rate of 20 percent is charged (after indexation benefit) while an FD continues to be taxed at the prevailing income tax slab rate. Because of Indexation, the effective tax rate is approx between 0% to 10%
If a choice has to be made for an investor in a 20 or 30 percent bracket to invest in a fixed deposit or a debt fund, he should go with debt fund and do away with fixed deposits, because the yield can be quite low or even negative, after factoring in the tax deduction and inflation.
- Taxation on Hybrid funds
A hybrid fund is a mix of different asset classes which helps manage return generation and risk factor. Hybrid funds can be equity-oriented (balanced funds) or debt-oriented (monthly income plans), and are taxed accordingly. In other words, a balanced fund with a minimum of 65 percent exposure in equities, is taxed like an equity mutual fund, while the tax treatment of a monthly income plan is in the same way as that of a debt mutual fund.
There are other types of hybrid funds like arbitrage funds which are taxed like equity funds, and ‘fund of funds’ which are taxed like debt funds.
Moreover, the scheme information document outlines it clearly if a mutual fund scheme is an equity or a debt product.
How is the holding period calculated in a mutual fund?
The holding period is calculated from the date of purchase of mutual fund units till the day you sell them. In case of an SIP, since you are purchasing a certain number of units in a regular fashion (for instance, every month), the period of holding is calculated on the basis of individual dates for these units. For instance, the units that are purchased in March 2016 completes one year in March 207, not January 2017.
How are dividends taxed?
When you choose the ‘dividend option’ you are entitled to receive dividends from the profits made from a mutual fund scheme. You do not have to pay any tax on these dividends, whether they are equity or debt schemes. However, since mutual fund houses have to pay a Dividend Distribution Tax (DDT) of 28.24 percent for dividends given in debt schemes, your dividends from debts are taxed at source. DDT is not applicable on dividend declared in equity mutual funds.
Happy Tax Saving!!!!