What are the tax implications of redeeming equity and debt mutual funds?

Mutual funds have grown exponentially in popularity as an investment option for Indian investors over the years. However, along with the returns generated from mutual funds comes an obligation to pay taxes. Read on to explore the various tax implications of redeeming equity and debt funds.

• Table of contents

1. How are redemptions of mutual funds taxed?
2. Types of returns in mutual funds
3. Tax on equity mutual funds
4. Tax on debt fund
5. Capital gains on SIPs and SWPs

How are redemptions of mutual funds taxed?

When redeeming mutual fund units, the difference between the sale value and purchase cost is considered a capital gain or loss. Capital gains on mutual funds are taxed at the time of redemption. The tax treatment depends on two main factors: the type of mutual fund (equity or debt) and the holding period (short-term or long-term).

For taxation purposes, an equity-oriented fund is considered to be one where at least 65% of the investment is in equity instruments (e.g., shares of domestic companies listed on a recognized stock exchange).

For equity funds, short-term is defined as holding for less than 12 months, and long-term is holding for more than 12 months. Short-term capital gains are taxed at 20%. Long-term capital gains are tax-exempt up to gains of Rs. 1.25 lakh. Thereafter, they are taxed at 12.5%.

Funds that invest more than 35% but less than 65% in equities will qualify for short-term capital gains if held for less than two years. They will be taxed at the investor’s applicable slab rate. Units held for more than two years will be taxed as long-term capital gains, at a rate of 12.5%.

Types of returns in mutual funds

To start, it is important to understand the two main types of returns that can be generated from mutual funds - Income Distribution cum Capital Withdrawal (IDCW) and capital gains.

IDCW income received from mutual funds is taxed as normal income according to the applicable tax slab rate. Capital gains arise when investors redeem or sell their mutual fund units and can be classified as either short-term or long-term depending on the holding period.

Tax on equity mutual funds

Equity mutual funds primarily invest in stocks and equities. If equity fund units are redeemed or sold within 12 months of purchase, any profits generated are considered short-term capital gains (STCG). STCG from equity funds is taxed at a rate of 20% with no exemptions. Bajaj Finserv AMC offers several mutual fund schemes, including the Bajaj Finserv Flexi Cap Fund, Bajaj Finserv Large Cap Fund, Bajaj Finserv Liquid Fund, Bajaj Finserv Multi Asset Allocation Fund and much more are taxed at a flat rate of 15%.

Capital gains earned from holding equity funds for more than 12 months are deemed long-term capital gains (LTCG). The first Rs. 1 lakh of annual LTCG from equity funds is exempt from taxation. Any gains over Rs. 1 lakh are taxed at the concessional rate of 10%. No indexation benefit is available for computing LTCG on equity funds.

Equity Linked Savings Schemes (ELSS) mutual funds, which have a statutory lock-in of 3 years to avail tax rebate u/s 80C of the Income Tax Act, 1961, are also taxed in the same manner as regular equity funds post the lock-in period. Equity-oriented hybrid funds, with a minimum 65% equity allocation, are also taxed like equity funds for capital gains realised.

Tax on debt fund

The capital gains tax treatment of debt mutual funds differs significantly from equity funds.

Units purchased before April 1, 2023 – Until March 31, 2023, any profits generated from redeeming debt funds within 36 months of purchase were considered short-term capital gains (STCG) and taxed according to the slab rates. Gains from long-term investments in debt funds (held for more than 36 months) were deemed long-term capital gains (LTCG). The LTCG is taxed at the rate of 20% with the benefit of indexation. Indexation reduces the impact of inflation on acquisition costs, thereby reducing the tax liability.

Units purchased on or after April 1, 2023 Gains from debt funds made after April 1, 2023, no longer receive indexation benefits and are considered to be short- term capital gains irrespective of the holding period. They are added to the investor’s taxable income and taxed at the applicable slab rate.

Capital gains on systematic investment plans (SIPs) and systematic withdrawal plans (SWPs)

When redeeming SIPs or SWPs, each instalment/withdrawal is considered a separate investment with its unique purchase date. So, the capital gains on early instalments could be short-term while those on later instalments may qualify as long-term based on completion of the holding period.

Understanding the capital gains tax rules is critical for Indian mutual fund investors to optimise their post-tax returns through appropriate fund selection and holding periods. Planning redemptions based on these tax rules can significantly reduce the tax outgo. If you are planning to invest regularly, a SIP calculator online will help you estimate the potential returns.

FAQs:

Are index funds taxed differently than regular equity funds?

No, index funds are also considered equity oriented mutual funds. So, the capital gains tax rules are the same - short term gains within 12 months taxed at 15% and long term gains above 12 months are tax-free up to Rs. 1 lakh and 10% on the excess amount.

Is there a limit on claiming capital gains tax exemption for equity mutual funds?

Yes, the long term capital gains tax exemption of Rs. 1 lakh per financial year is applicable on total gains from all specified capital assets like equities, equity mutual funds etc. Exemption cannot be claimed separately for each asset class.

Are capital gains indexed to inflation for equity funds?

No, indexation benefit is not available for computing long term capital gains from equity funds and equity-oriented funds.

What changes were made to the taxation of debt mutual funds after April 1, 2024?

Prior to budget 2023, debt mutual fund units held for less than three years were taxed as short-term capital gains. The tax rate was as per the investor’s tax slab. Long term capital gains on units held for more than three years were taxed at 20%, with indexation benefits. Thereon, the following changes were introduced:

1. 2023 Budget announced that for all debt fund units purchased after April 1, 2023, all capital gains would be considered as short-term capital gains, regardless of the holding period, and taxed as per the individual’s prevailing tax slab. Units purchased before April 1, 2023 would follow the earlier tax structure.
2. The 2024 Budget upheld the changes made to units purchased after April 2023. It also made changes to the taxation on units purchased before April 2023. Capital gains on those units will now be considered short-term if sold within 2 years. The tax rate will be as per the tax slab. Long-term capital gains (on units held for more than 2 years) will be charged at 12.5%. The indexation benefit has been removed.

How are capital gains from debt mutual funds taxed for investments made before April 1, 2024?

As mentioned above, capital gains on all debt fund units purchased after April 1, 2023, are considered short-term capital gains and taxed as the investor’s applicable slab rates.

What is the new LTCG tax rate for debt mutual funds after the 2023 Budget?

There is no longer any LTCG rate on debt mutual funds. Capital gains on all debt fund units purchased after April 1, 2023, are deemed to be short-term capital gains and taxed as per the investor’s applicable slab rate.

Will the removal of indexation benefits impact my tax liability on debt mutual funds?

Yes, it is likely to increase the tax rate, as gains will no longer be adjusted for inflation.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as 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.