Taxation of Mutual Funds: Everything You Need to Know

Posted On: 31 March 2023

When it comes to investing in mutual funds, you cannot overlook the taxes associated with them. However, we say that’s the glass-half-empty way of looking at things. The glass-half-full version? The more tax you need to pay, the more money you’re making, right?

Let’s understand how mutual fund taxation in India works, and if there are ways to minimise your tax liability.

Table of contents

What is tax on mutual funds?
What are the latest rules for mutual fund taxes?
How do mutual funds generate returns?
Taxation of mutual funds
What are the taxes applicable on capital gains?
What are the factors to determine tax on mutual funds?
Tax on equity mutual fund
Tax on hybrid mutual fund
Tax on debt mutual fund
What are the taxes applicable on IDCW?
How do mutual funds generate profits

What is tax on mutual funds?

The profits obtained from investing in mutual funds are referred to as capital gains. These capital gains are taxable, so it is important to understand the tax implications of your investment returns before investing in mutual funds. Additionally, there may be opportunities to benefit from tax deductions in certain cases.

What are the latest rules for mutual fund taxes?

In the 2023 Union Budget, it was announced that debt mutual funds (those investing less than 35% in equities) would no longer provide indexation benefits on long-term capital gains. Irrespective of the holding period, all gains from debt mutual funds would be taxed according to the investor’s applicable tax slab. This change applies only to debt fund investments made after this date.

In Budget 2024, further changes were made. The long-term capital gain tax on equity funds (applicable after a holding period of one year) was increased from 10% to 12.5%, and the exemption limit was raised from Rs. 1 lakh to Rs. 1.25 lakh. The short-term capital gains tax was raised from 15% to 20%.

No changes were made to the taxation of debt fund units purchased after April 2023. However, for units purchased before April 2023, the long-term capital gains tax is now 12.5% without indexation and the holding period to qualify for LTCG was reduced from 36 months to 24 months.

How do mutual funds generate returns?

Mutual funds invest in stocks, debt securities, or other instruments to generate profit for investors. If you are a unit holder, these profits are distributed to you through two methods, each of which attracts a different type of tax. These are:

Capital Gains: If you buy a mutual fund unit and sell it at a higher price, the profit generated is considered a capital gain and will attract capital gains tax.
Income Distribution cum Capital Withdrawal (IDCW): As a unit holder in a mutual fund, you will receive IDCW that is declared by fund houses subject to availability of distributable surplus. These IDCW will also be subject to tax.

Taxation of mutual funds

The taxation of mutual funds is determined by the holding period and the type of fund. However, debt mutual funds, which invest less than 35% in equity shares, will be considered short-term, irrespective of the holding period. The table below shows the tax rates as per Budget 2024.

Fund Type	STCG	LTCG
Equity-oriented mutual funds (schemes investing at least 65% in equity)	20%	12.5%, with exemption of Rs. 1.25 lakh
Debt Mutual Funds (less than 35% in equities)	Slab Rate	Slab Rate
Other funds (invest more than 35% but less than 65% in equity)	Slab Rate	12.5%

What are the taxes applicable on capital gains?

The amount and type of tax levied on capital gains will depend on various factors such as your choice of fund, the holding period of the fund, and your income tax slab. Before we discuss these factors, it’s important to note that as part of The Finance Bill, 2023, the government announced changes to the mutual fund taxation rules, which effectively split mutual funds into three categories from a taxation standpoint.

Category	Change to Tax Treatment
Equity Exposure of More Than 65% (Equity-Oriented Mutual Fund)	No
Equity Exposure of Less Than 65% But Above 35% (Hybrid Fund)	Same Tax Rules as Those That Applied to Non-Equity-Oriented Funds Before
Equity Exposure Less Than 35% (Debt Fund)	New Tax Rules

Here is how tax on mutual fund is applied for each of the categories described above, as per the new rules.

What are the factors to determine tax on mutual funds?

Fund types: Different types of mutual funds are subject to varying taxation rules. Equity mutual funds, debt mutual funds, hybrid mutual funds, etc., are all taxed differently.
Dividend: A dividend is a portion of the mutual fund's profit that is distributed to investors by mutual fund houses.
Capital gains: Capital gains refer to the profit earned when investors sell their capital assets at a higher price than their total investment amount.
Holding period: The holding period is the time between purchasing and selling mutual fund units. According to India's income tax regulations, holding an investment for a longer period leads to lower tax liability. Therefore, the holding period affects the tax rate on capital gains. The longer the holding period, the lower the tax liability.

Tax on equity mutual fund

A mutual fund is considered an Equity-Oriented Mutual Fund if it invests more than 65% of its assets in stocks. If you invest in an equity fund but sell it within 12 months and make a profit, you will be liable to pay Short-Term Capital Gains (STCG). The STCG levied in this case will be 15% of the profit. You must note that applicable surcharge and cess will also have to be paid, and this tax is irrespective of the income tax slab one belongs to.

However, if you stay invested in the fund for more than a year, any profit at the time of sale will be considered a Long-Term Capital Gain (LTCG). The LTCG tax rate is 10% on gains of over Rs 1 lakh. Also, there is a 15% surcharge that must be paid.

So, if you make a profit of Rs.1.1 lakh in a financial year, you pay LTCG of Rs 1,000 (10% of Rs 10,000, which is the amount exceeding Rs.1 lakh). (For illustrative purpose)

Tax on hybrid mutual fund

If your fund’s equity exposure is less than 65% but above 35%, and you sell the units in under 3 years, your profits will be considered short-term capital gains. In this case, STCG tax will be charged at your income tax rate.

However, if you hold it for more than 3 years, you will pay Long-Term Capital Gains (LTCG) at a tax rate of 20% with an indexation benefit.
Indexation leads to a lower effective tax rate as it adjusts your fund purchase price for inflation. For instance, if you purchased 100 units of a fund at Rs.100 and sold them at Rs.150 after three years. Assuming an inflation rate of 5% in each of those years, your purchase price will be considered Rs.115.76 (Rs 100 compounded at 5% for three years).

So, your tax outgo will be as follows: [(150 - 115.76) x 100 units] = Rs.3,424. Instead of [(150 - 100) x 100 units] = Rs 5,000. (For illustrative purpose only) The government announces the rate of inflation for every financial year through its ‘cost inflation index’.

The above tax rule was previously applicable for both hybrid mutual funds and debt mutual funds (or all non-equity-oriented mutual funds). However, it now applies only to hybrid mutual funds.

Tax on debt mutual fund

From April 1, 2023, for mutual funds that invest less than 35% in equity (typically debt mutual funds), you will need to pay tax on mutual fund gains at your income tax rate. This means you will not be able to benefit from indexation while calculating long-term capital gains on your debt mutual funds.

There’s one last point you need to know about the recent tax changes. To make sure that the new tax rules come into effect prospectively (or going forward), the government allows the benefit of ‘grandfathering’.

As part of grandfathering, an investor's purchase price in the new system will be considered to be that of the first day of the rule.

The below example will clarify how this works.

Suppose you hold a debt mutual fund unit purchased at Rs.100 on April 1, 2020. As of April 1, 2023, the NAV may have risen to Rs 120. Now if you sell the debt fund unit on March 31, 2024, at a price of Rs 125, you will pay LTCG for the duration of the first three years you held the units (between 2020 and 2023) while for the final year, you will pay tax on the Rs.5 gain as per your income tax slab. (For illustrative purpose only)

What are the taxes applicable on IDCW?

You will need to pay tax on IDCW received from your mutual fund as per your income tax slab. So, if you are in the 30% tax bracket, you will incur the same rate of tax on IDCW that you earn. Mutual fund companies apply 10% Tax Deducted at Source (TDS), so you can adjust this amount when you pay your taxes.

How do mutual funds generate profits?

Mutual funds can generate profits through capital gains or dividend income.

Capital gains: These occur when an asset is sold for more than its purchase price. In mutual funds, you realize capital gains only when you redeem your fund units. So, you only need to pay taxes on these gains when you file your income tax returns for the year of redemption.
Income Distribution cum Capital Withdrawal (IDCW)Mutual funds may distribute a portion of their earnings to investors as IDCW. It is declared based on the fund's surplus and are subject to tax when received. As a result, you must pay tax on any IDCW payout you receive from the mutual fund in the year they are distributed.

Understanding these types of profits can assist you in effectively managing your investments and meeting your tax obligations.

Conclusion

Mutual fund investments can offer various benefits such as diversification, potential for long term growth, and tax benefits. However, investors need to be aware of the tax implications of mutual fund investments to make informed investment decisions.

An important point to remember is that capital gains tax is not deducted at source unless you are a Non-Resident Indian. This means that if you make a profit, you are required to pay tax when you file your income tax on mutual fund returns.
While we have tried our best to break this topic down simply, if you have any doubt about mutual fund taxation or tax saving strategies, you should consult a chartered accountant or financial advisor for further clarity.

FAQ

How are mutual funds taxed?

Profits generated by a mutual fund are typically taxed as short-term capital gains or long-term capital gains. The tax rate can vary depending on the investor’s choice of fund, holding period, and income tax rate.

How should I pay tax on mutual funds?

Mutual fund companies do not typically deduct tax at source. This means that the responsibility falls upon the investors to declare their taxes at the time of filing returns.

Are mutual fund taxes payable every year?

Capital gains taxes on mutual fund are payable only when you redeem your mutual fund units. However, IDCW payments, if received, will be taxed as dividends as per the individual’s tax slab at the end of the financial year.

Is it possible to avoid capital gains tax?

The only scenario in which you may be able to avoid capital gains tax is if your long-term capital gains are within the Rs. 1.25 lakh exemption for equity-oriented mutual funds. Equity-oriented mutual funds qualify for long-term capital gains tax if units are held for a year or more. Gains of up to Rs. 1.25 lakh are tax-exempt. Thereafter, the tax rate is 12.5%

However, short-term capital gains on equity-oriented funds are taxed at 20%, with no exemptions. In all other mutual fund categories too, capital gains tax cannot be avoided.

What are the factors to keep in mind before choosing tax-saving mutual funds?

When selecting an ELSS fund, consider aligning it with your financial goals and ensuring you can keep your investments locked-in for at least three years. Evaluate past performance* data (if available), risk profile, fund manager's expertise and the expense ratio. Look for funds with a diversified portfolio.

*Past performance may or may not be sustained in the future.

Can mutual fund investments help me get a rebate on income tax?

There are typically no tax rebates on mutual funds, but Investing in ELSS funds offers tax deductions under Section 80C of the Income Tax Act, 1961. Investments of up to Rs 1.5 lakh in ELSS and other instruments listed under this Section can be deducted from the investor’s taxable income.

Are wealth taxes applicable to MF investments?

Wealth taxes do not apply to mutual fund investments in India. Instead, capital gains tax is applicable on profits from the sale of mutual fund units.

What are tax saving mutual funds?

ELSS funds are tax saving funds that offer tax benefits as well as long-term growth potential. They qualify for tax deductions under Section 80C of the Income Tax Act, 1961, reducing an investor’s taxable income by up to Rs 1.5 lakh in a financial year. These funds, primarily equity-oriented, have a 3-year lock-in period and can be suitable for investors seeking long-term capital appreciation potential and have a high risk appetite.

How much mutual fund is tax-free?

Long-term capital gains in equity-oriented mutual funds are tax-free up to Rs 1.25 lakh per financial year. Gains exceeding this amount are taxed at 12.5%.

How do mutual funds generate taxable income?

Mutual funds generate taxable income through capital gains and IDCW payouts. Capital gains are realized when units are sold, either as short-term (taxed at higher rates) or long-term (taxed at lower rates). IDCW payouts are taxed as per the investor’s prevailing tax slab.

This document should not be treated as endorsement of the views/opinions or as an investment advice.
This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.