Tax on Mutual Fund Profits
When you make an investment decision, it’s imperative to consider the tax implications behind it. The taxation rules applicable to the investment profits may bring down your returns considerably.
For example, suppose you get seven to eight percent interest by investing in a fixed deposit scheme. Now, since the returns from fixed deposits are fully taxable, the effective rate of return for you (considering that you fall in the highest tax bracket) after deducting the taxes would be around five to six percent only.
That is where mutual funds score over other investment avenues as they offer tax-efficient returns. Mutual funds collect capital from the investors and pool them into a range of securities, including company shares, bonds, and stocks.
How do you earn profits from mutual funds?
The profits from mutual funds are distributed to the investors in two forms:
Capital gains refer to the profits made by investors upon selling or transferring the mutual fund units. In other words, capital gains are the profits realized by the investors due to the price appreciation of the mutual fund units held by them.
On the other hand, dividends refer to the profit payouts paid by the mutual fund company to investors. When companies make profits, they decide to share a portion of them with their investors in dividends. And investors receive the dividends based on the number of mutual fund units they are holding.
Both capital gains and dividends are taxable in the hands of the investors. Let’s learn about the taxation rules applicable for the profits generated from mutual funds.
Taxation on capital gains
Capital gains acquired from the mutual funds are classified into two types:
Long-term capital gains (LTCG)
Short-term capital gains (STCG)
The taxation rules applicable for capital gains on mutual funds are different for different types of capital gains. So, to understand the tax implications on them, you need first to understand the difference between the two types of capital gains.
As you know, mutual funds are of two types – equity mutual funds (funds with equity exposure of more than 65%) and non-equity mutual funds or debt funds (funds that invest in fixed income securities). The definition of LTCG and STCG is different for these two types of mutual funds.
In the case of equity mutual funds, if an investor gains profits after holding the funds for more than 12 months, they are categorized as long-term capital gains. On the contrary, profits earned on these mutual funds before 12 months are known as short-term capital gains.
Whereas, in the case of debt mutual funds, if the holding period is more than 36 months, their profits are classified as long-term capital gains. If the holding period is less than that, their profits are considered short-term capital gains.
Taxation on LTCG
Long-term capital gains of up to Rs. 1 lakh on equity mutual funds are exempted from income tax. However, if they exceed Rs. 1 lakh, they are taxed at 10% + 4% cess. On the other hand, LTCG from non-equity mutual funds is taxed at a flat rate of 20% after indexation.
Taxation on STCG
In the case of equity mutual funds, short-term capital gains are taxed at the flat rate of 15% without indexation benefits. Whereas, in the case of non-equity funds, the STCG is added to the investor’s annual income and is taxed as per the applicable income tax slab rate.
Taxation on Dividend
Earlier, dividends of up to Rs. 10 lakhs from mutual funds used to be tax-free in the hands of the investors. However, after the amendments made in the Union Budget 2020, the dividends provided by the mutual fund schemes are taxed like the regular income from other sources.
They are added to the annual taxable income of the investors and are taxed as per the applicable income tax slab rates. The fund house can deduct a TDS of 10% on dividends paid to an investor if they exceed Rs. 5,000 in a year for all schemes of the same fund house.
What is stamp duty?
From 1st July 2020, all mutual fund investors are required to pay a stamp duty tax of 0.0005% on the value of the new mutual fund units purchased by them. These charges are applicable regardless of the type of mutual fund. The stamp duty tax is cut directly from the amount invested by the investor in the mutual fund scheme.
Mutual funds are one of the most tax-effective investment instruments that can provide you with inflation-beating returns. In the case of capital gains, you are required to pay taxes only when you redeem your mutual fund units. Also, the longer you hold your mutual funds, the more tax-efficient they become since LTCG taxation is comparatively lower than STCG taxation.
Thank you for reading this post, don't forget to subscribe!