One of the reasons why people invest is to accumulate wealth in the form of capital gains, dividends, and interest income. However, this income or profit which you generate from all such activities is taxable in the hands of the law. The tax that is required to be paid on the gains depends on the duration for which you remain invested in the instrument.

In this blog, will discuss the tax aspects of mutual funds and what are the parameters that determine mutual fund taxation.  Read on!

What Is Holding Period?

As stated previously, the duration for which you hold onto security is known as the holding period of mutual funds. Following are the two different types of holding period –

1. Long-Term Holding Period

The holding period is dependent on the period and additionally on the asset class. In case of equity and balanced funds, if the fund is held for more than one year, the period is regarded as long-term. In this scenario, long-term capital tax is levied.

For the debt funds and debt-oriented hybrid funds such as Monthly Income Plans, the investment period of 36 months is considered as long-term.

2. Short-Term Holding Period

If the equity or balanced funds (also known as equity-oriented hybrid funds) are held for less than 12 months, then the investment is considered as a short-term investment, and short -term capital gain tax is levied on the same.

In case of debt funds, if the fund is held for less than 36 months, a short-term capital gains tax is levied. Some of the examples of short-term securities include treasury bills, commercial papers, and the likes.

Funds Short-term Long-term
Equity funds < 12 months > 12 months
Hybrid Funds (Equity Oriented) < 12 months > 12 months
Hybrid Funds Debt Oriented) < 36 months > 36 months
Debt funds < 36 months > 36 months

Taxation On Mutual Funds 

1. Tax Saving Equity Funds 

Among equity funds, the Equity Linked Savings Scheme (ELSS) is the most efficient way of saving tax. ELSS provides tax benefits of Rs 1.5 Lakh under section 80C of the Income Tax Act. These funds are diversified funds that invest across the market capitalization of the market. Given ELSS provides tax benefits, they come with a lock-in period of three years in which an investor is not allowed to redeem the investment.

After redemption, if the gain (long-term capital gain as you have to hold the funds for minimum three years, and it crosses the threshold of one-year requirement) is over Rs 1 Lakh, you will be required to pay taxes at 10% without indexation benefit.

2. Non-Tax Saving Equity Funds

If you are investing in non-tax saving equity funds such as mid-cap funds, or small-cap or bluechip funds, then the long-term capital gain (LTCG) is taxed at 10% over Rs 1 Lakh. If the gain is less than Rs 1 Lakh, you will not be taxed.

3. Debt Funds

In the case of debt funds, the tax is at 20% after indexation for long-term capital gain.

For our novice readers, indexation is the way by which you can factor in the increase in price (i.e., inflation) during the period of holding the investments. This helps you rebase the cost of your investment on the day which you are selling.

In the case of short-term capital gain, the income from the debt funds is added to your income tax, and the tax is dependent on your slab.

Let us see an example –

Mr. A is a businessman who is earning Rs 20 Lakhs per year and falls under 30% tax bracket. Mr. A invests Rs 1 Lakh each in two bonds A and B on April 1, 2018. Mr. A redeemed the bond A in September 2018 and fetched Rs 1.1 Lakhs from the redemption. Also, Mr. A redeemed the other bond B in June 2019 (after one year of investment) and fetched Rs 1.25 Lakhs. During the period 2018-19, inflation was 10%.

If we have to calculate the tax –

Long-term tax

Profit – Rs 1.25 Lakhs – Rs 1.00 Lakhs

= Rs 25,000

Indexation = 10% x Rs 1.00 Lakhs

= Rs 10,000

Net profit = Rs 25,000-Rs 10,000

= Rs 15,000

Tax = 20% of profit

= 20% x 15000

= Rs 3000

Short-term tax

Profit – Rs 1.1 Lakhs – Rs 1.0 Lakhs

= Rs 10,000

Income = Rs 25 Lakhs

Tax bracket = 30%

Rs 10,000 is added in 25 Lakhs and 30% is levied on that.

Hybrid Funds

Hybrid funds are the ones that invest in both equity and debt asset class. In this case, the treatment of tax is dependent on the composition of the asset class.

  1. Equity oriented hybrid funds (also known as balanced funds) have 65% of their assets towards equities. Thus, the tax treatment on these funds is precisely the same as non-tax saving equity funds.
  2. Debt oriented hybrid funds (also known as MIP funds) have 65% of their assets towards debt. Thus, the tax treatment on these funds is precisely the same as debt funds.

How are SIPs taxed?

A SIP or Systematic Investment Plan is the process by which you contribute a fixed amount at a regular interval (daily, weekly, fortnightly, monthly, or even quarterly) in a mutual fund. Every contribution is considered as a new investment and thus are taxed separately and will have a different holding period.

For example, if you start a SIP in an equity fund for six months from January 1, 2019, the contribution on January 1 will be treated separately when compared to the contribution of February 1, 2019, and so on.

Now, on January 1, 2020, your first contribution will complete 12 months and will be taxable as long-term if you redeem, but others will be considered as short-term as they would not have completed 12 months.

Conclusion 

To conclude, we can say, mutual funds are instruments for long-term investments and make sense if you remain invested for a longer-term. The longer you hold onto your mutual fund units, the more tax-efficient they become as the long-term taxation is generally lower as compared to the short-term tax.

Funds Less than 1 year 1-3 year More than 3 years
Equity funds 15% 10% without indexation (if gain > Rs 1 Lakh) 10% without indexation (if gain > Rs 1 Lakh)
Hybrid Funds (Equity Oriented) 15% 10% without indexation (if gain > Rs 1 Lakh) 10% without indexation (if gain > Rs 1 Lakh)
Hybrid Funds Debt Oriented) Added to slab Added to slab 20% with indexation benefit
Debt funds Added to slab Added to slab 20% with indexation benefit

Disclaimer: The views expressed in this post are that of the author and not those of Groww