The gains that you earn from your mutual fund investments are also a form of income (capital gains) and they too are taxed (capital gains tax). The taxation on mutual fund gains vary as per the holding period and depending on the type of mutual fund.

In Union Budget 2018, Finance Minister introduced two major changes to Equity Mutual Funds in terms of Long Term Capital Gain (LTCG) Tax and Dividend Distribution Tax (DDT).

As a result of the announcement, the stock markets reacted negatively with the benchmark Sensex falling more than 800 points immediately as investors’ sentiments dampened and they rushed for selling their holdings. So, Lets understand taxation on different types of mutual funds in detail.

Read MoreKey highlights of Budget 2018, After effect and what experts are saying till now

Type of Mutual Funds

A lot of people follow stock markets and wish to invest in the shares offered by various companies, but they fear that they don’t have enough knowledge or don’t have sufficient time to keep track on and follow the latest buzz about the dynamic market. Mutual fund is the perfect solution for them as investing directly in equity market is a risk, not everyone willing to take.

A mutual fund is an investment instrument, basically collection of stocks and/or bonds, managed by professionals of an asset management company. Investors will put their money in different types of mutual fund units depending on their risk appetite and duration of investment.

There are different 3 major types of mutual funds in India:

Equity Mutual Funds

Invest most of the money gather from investors into stock market. The risk level in equity mutual funds are quite high and investors are advice to invest in these funds as per their risk appetite.

Debt Mutual Funds  

Invest most of the money gather from investors into debt instruments like corporate bonds, government bonds, bonds issued by banks etc. These mutual funds are best for investors who are risk averse.

Balanced Mutual Funds 

Invest the money gather into both debt and equity. These are diversified mutual funds having perfect balance between risk and returns on investment, and are most popular mutual funds these days.

Holding Period in Mutual Funds

Capital gain on mutual funds is referred to the profit that an investor makes by redeeming or selling the mutual fund unit. It can either be Short Term Capital Gain (STCG) or a Long-Term Capital Gain (LTCG) depending on holding period of fund. Tax applicable on capital gain is known as Capital Gain Tax.

These are the holding period defined for different types of mutual funds :

 Type

Short-term holding

Long-term holding

Equity funds

Less than 12 months

12 months and more

Balanced funds

Less than 12 months

12 months and more

Debt funds

Less than 36 months

36 months and more

Now that we understand how short-term and long-term is defined, let’s see how short-term gains and long-term gains are taxed on different types of mutual funds.

Taxation on Debt Mutual Funds

Different types and schemes of debt oriented mutual funds are available in market. Taxation on all these debt funds are calculated in similar manner. Types of debt funds are Gilt Funds, Income Funds, Monthly Income Plans (MIPs), Short term funds, Liquid Funds and Fixed Maturity Plans (FMPs).

Following are the various taxation on Debt Mutual Funds :

Tax on Capital gain

Say Ravi investing an amount of ₹ 10 lacs in debt mutual funds with around 10% returns annually.

First, decide the investment period in the funds, i.e. the difference between start/purchase date and selling date of units. Taxes upon debt mutual funds are of two types depending upon the period for which they are held.

These two types are:

Short-term Capital Gain tax on Debt Funds

This is applicable on debt mutual funds held for a period of 36 months or less i.e. anything less than 3 years. In short-term capital gain tax, tax on funds is calculated as per income tax slab of the individual, i.e. 5%, 20% or 30% on the amount of gain.

For Example,

Ravi is a sales manager currently earning ₹ 10,00,000 per annum and invested amount ₹ 10,00,000 in debt mutual funds for 2 years. The returns earned on this instrument will fall under short-term capital gains and will be taxed as per the Income Tax bracket of Ravi, that is 20% as per Income Tax Act of 2016-17.

Wits 10% ROI, Ravi earned a return of ₹ 2,00,000 on this debt mutual fund, then according to his tax bracket, he will have to pay 20% of ₹ 2,00,000 as interest which comes down to ₹ 40,000.

Long-term Capital Gain tax on Debt Funds

This is applicable on debt mutual funds held for a period of 36 months or more i.e. anything more than 3 years. In long-term capital gain tax, tax on funds is calculated at the rate of 20% with cost indexation on the amount of gain.

Indexation is the adjustment of your purchase price with respect to effect of inflation in an economy and helps you to pay low taxes on your capital gain.

For Example,

Ravi invested amount ₹ 10,00,000 in debt mutual funds for 5 years. Since this fund is held for more than 3 years, the returns earned on this instrument will fall under long-term capital gains with indexation at 20 %. Now calculate the Indexed cost.

Indexed cost = (Cost of investment) X (CII for the year of sale/ CII for the year of purchase)

CII stands for Cost Inflation Index where the base year is FY 1981-82. The cost inflation index number is released each year by the central tax authorities. As future CII is not known, so let’s say Ravi investment in FY 2011-12 and sale the debt mutual bond in FY 2016-17.

So now we have,

CII for FY 2011-12- 758

CII for FY 2016-17- 1125

Cost of investment = ₹ 10,00,000

Indexed Cost = (1125/758) X 10,00,000 = ₹ 14,84,169

Hence, Long-term Capital gains

= ₹ 10 lakhs @ 10 % for 5 years – ₹ 14,84,169

= ₹ (15,00,000-14,84,169)

= ₹ 15,831 is long term capital gain which will attract tax @ 20 %.

The tax liability with indexation is 20 % of ₹ 15,381 which is roughly equivalent to ₹ 3166. This indexation helps in lessen the tax burden by taking inflation in account.

Hope you understand all about how taxation works on capital gain from debt mutual fund.

Tax on Dividend

While dividends in debt oriented schemes are nil, there is a catch known as the dividend distribution tax (DDT). DDT is a tax that is imposed by the government on companies based on dividend paid to a company’s investors.

The DDT in debt mutual funds was introduced to reduce the arbitrage between bank fixed deposit and debt funds. DDT will reduce in-hand returns of investors. Fund houses have to deduct DDT before declaring dividend as dividends received from all mutual funds are tax-free in the hands of the investors.

However, the investor does not pay this tax, at least not directly. The fund house deducts it from the NAV of the scheme to the extent of statutory levy (if applicable) and pursuant to the payout of the dividend the NAV of the scheme would fall to the extent of payout and statutory (if applicable).

DDT on all non-equity funds such as money market, liquid, and debt funds is 25 % plus 12 % surcharge plus 3 % cess, totalling to 28.84 %.

It can be broken up as

25 %+ (12 % *0.25)+ 3 % *(0.25+ 12 % *0.25) = 28.84

Investors need to be careful while considering debt funds especially the dividend option. Also, any Systematic Transfer Plans (STP) would also count as a redemption and might be subject to taxation depending on the fund.

Taxation on Equity Mutual Funds

Different types and schemes of equity oriented mutual funds are available in market. Taxation on all these Equity oriented funds are calculated in similar manner. Types of equity funds are Large cap funds, Mid cap funds, Small cap funds, Balanced funds, Sector Mutual Funds, Equity Linked Savings Scheme (ELSS) and Index funds.

Following are the various taxation on Equity Mutual Funds :

Tax on Capital gain

Taxes upon debt mutual funds are of two types depending upon the period for which they are held.

These two types are:

Short-term Capital Gain tax on Equity Funds

This is applicable on equity mutual funds held for a period of 12 months or less i.e. anything less than 1 years. In short-term capital gain tax rate on these funds is 15 % per annum on the amount of gain (No changes in the Budget 2018 in this regard).

For Example,

Ravi is a sales manager earning ₹ 10,00,000 per annum and invested amount ₹ 1,00,000 in equity mutual funds for 1 years. The returns earned on this instrument will fall under short-term capital gains and will be taxed at 15 % % per annum on the amount of gain.

Wits 10% ROI, Ravi earned a return of ₹ 10,000 on this equity mutual fund, then he will have to pay 15 % of ₹ 10,000 as tax which comes down to ₹ 1500.

Long-term Capital Gain tax on Equity Funds

This is applicable on equity oriented mutual funds held for a period of 12 months or more i.e. anything more than 1 years. In long-term capital gain tax rate on equity funds before the announcement of union budget 2018 was NIL.

In union budget 2018, Finance Minister has introduced a Long-Term Capital Gains Tax of 10% for Capital Gains exceeding ₹ 1 lakh in a year. This tax will be charged without providing the benefit of indexation like in case of debt mutual funds.

Read more: 3 Reasons Why Equity Mutual Fund is Good Even After LTCG Tax

The big move introduced to bring in LTCG tax is a major amendment impacting all investors including foreign portfolio investors as well as retail investors. The Union Budget 2018 proposes that LTCG tax will have to be paid on profit booked after March 31, 2018.

This means if you sell before March 31, 2018, a stock or an equity mutual fund that has been held for more than a year, you do not pay tax. But, if you sell it on or after April 1, LTCG tax will apply on the gains made and only the gains accruing from February 1, 2018 will be subject to the LTCG tax.

Also, this tax is applicable only if LTCG is above ₹ 1 lakh in a financial year. So, if an investor made long-term gains of ₹ 1,20,000 in a year, LTCG tax is applicable only for ₹ 20,000 i.e. ₹ 1,20,000 – ₹ 1,00,000.

The budget 2018 also talks aboutGrandfatheringin LTCG. The ‘grandfathering’ clause is the exemption granted to existing investors or gains made by them before the new tax law comes into force. Whenever the government introduces a stricter tax law, it has to ensure that investors who have committed money keeping in mind the easier tax regime are protected. In the matter of LTCG tax on shares, the government said gains from shares or equity mutual funds made till January 31, will be grandfathered – or exempted. There will be no LTCG tax on notional profit in shares till then.

Now let’s see the various scenario for calculation of LCTG tax with Example.

Case 1 : If stocks or equity mutual fund are sold before 31st march 2018

CASE-1 Pre-budget Post-budget
Date of Purchase 01-Jan-17 01-Jan-17
Purchase Price (per unit) ₹ 1,000 ₹ 1,000
Date of Sale 25-Mar-18 25-Mar-18
Sale Price (per unit) ₹ 1,500 ₹ 1,500
FMV (per unit) on 31 Jan 2018 ₹ 1,300 ₹ 1,300
No. of Units 1 1
Computation of taxes on LTCG on Equity Funds
Sale consideration ₹ 1,500 ₹ 1,500
Less: Cost of acquisition considered ₹ 1,000 ₹ 1,300
Capital Gains/Loss ₹ 500 ₹ 200
Exempted ₹ -500 ₹ -200
Net Capital Gains
Tax at 10%

Case 2 : If stocks are sold after 31st march 2018 and FMV is more than purchase value

CASE-2 Pre-budget Post-budget
Date of Purchase 01-Jan-17 01-Jan-17
Purchase Price (per unit) ₹ 1,000 ₹ 1,000
Date of Sale 01-Apr-18 01-Apr-18
Sale Price (per unit) ₹ 1,500 ₹ 1,500
FMV (per unit) on 31 Jan 2018 ₹ 1,300 ₹ 1,300
No. of Units 1 1
Computation of taxes on LTCG on Equity Funds
Sale consideration ₹ 1,500 ₹ 1,500
Less: Cost of acquisition considered ₹ 1,000 ₹ 1,300
Capital Gains/Loss ₹ 500 ₹ 200
Exempted ₹ -500
Net Capital Gains ₹ 200
Tax at 10% ₹ 20

Case 3 : If stocks are sold after 31st march 2018 and FMV is less than purchase value

CASE-3 Pre-budget Post-budget
Date of Purchase 01-Jan-17 01-Jan-17
Purchase Price (per unit) ₹ 1,000 ₹ 1,000
Date of Sale 01-Apr-18 01-Apr-18
Sale Price (per unit) ₹ 1,500 ₹ 1,500
FMV (per unit) on 31 Jan 2018 ₹ 500 ₹ 500
No. of Units 1 1
Computation of taxes on LTCG on Equity Funds
Sale consideration ₹ 1,500 ₹ 1,500
Less: Cost of acquisition considered ₹ 1,000 ₹ 1,000
Capital Gains/Loss ₹ 500 ₹ 500
Exempted ₹ -500
Net Capital Gains ₹ 500
Tax at 10% ₹ 50

Case 4: If stocks are sold after 31st march 2018 and Selling value is less than FMV but more than purchase value

CASE-4 Pre-budget Post-budget
Date of Purchase 01-Jan-17 01-Jan-17
Purchase Price (per unit) ₹ 1,000 ₹ 1,000
Date of Sale 01-Apr-18 01-Apr-18
Sale Price (per unit) ₹ 1,300 ₹ 1,300
FMV (per unit) on 31 Jan 2018 ₹ 1,500 ₹ 1,500
No. of Units 1 1
Computation of taxes on LTCG on Equity Funds
Sale consideration ₹ 1,300 ₹ 1,300
Less: Cost of acquisition considered ₹ 1,000 ₹ 1,500
Capital Gains/Loss ₹ 300 ₹ -200
Exempted ₹ -300
Net Capital Gains ₹ -200
Tax at 10% NIL

Case 5: If stocks are sold after 31st march 2018 and Selling value is more than FMV but less than purchase value

CASE-5 Pre-budget Post-budget
Date of Purchase 01-Jan-17 01-Jan-17
Purchase Price (per unit) ₹ 1,000 ₹ 1,000
Date of Sale 01-Apr-18 01-Apr-18
Sale Price (per unit) ₹ 800 ₹ 800
FMV (per unit) on 31 Jan 2018 ₹ 500 ₹ 500
No. of Units 1 1
Computation of taxes on LTCG on Equity Funds
Sale consideration ₹ 800 ₹ 800
Less: Cost of acquisition considered ₹ 1,000 ₹ 1,000
Capital Gains/Loss ₹ -200 ₹ -200
Exempted
Net Capital Gains ₹ -200
Tax at 10% NIL

Case 6: If stocks are sold after 31st march 2018 and FMV is equal to purchase value and both are more than selling value

CASE-6 Pre-budget Post-budget
Date of Purchase 01-Jan-17 01-Jan-17
Purchase Price (per unit) ₹ 1,000 ₹ 1,000
Date of Sale 01-Apr-18 01-Apr-18
Sale Price (per unit) ₹ 800 ₹ 800
FMV (per unit) on 31 Jan 2018 ₹ 1,000 ₹ 1,000
No. of Units 1 1
Computation of taxes on LTCG on Equity Funds
Sale consideration ₹ 800 ₹ 800
Less: Cost of acquisition considered ₹ 1,000 ₹ 1,000
Capital Gains/Loss ₹ -200 ₹ -200
Exempted
Net Capital Gains ₹ -200
Tax at 10% NIL

The impact is not very bad because of provision which allows the cost of acquisition to be taken as the market value on 31st January 2018 (as we have seen in above calculations).

However, obviously a 10% tax has been levied on the capital gains calculated as above which was not there earlier, so will definitely hurt the equity oriented investors. But our stock exchange has become matured enough over the last couple of years, to attract the foreign and retail investors.

For detail analysis of impact of LCTG tax, read more : LTCG Tax 2018: How Will This Affect Your Mutual Funds

Tax on Dividend

Finance minister, Mr. Arun Jaitley, in his Union Budget 2018 speech has proposed to introduce DDT on equity mutual funds at the rate of 10%, to provide a level field across growth-oriented and dividend distributing schemes.

DDT will reduce in-hand returns of investors. Fund houses have to deduct DDT before declaring dividend. With this tax, investors relying on dividends from equity funds such as balanced funds might have to reconsider their investment strategies.

Analysts say, now growth option could be more suitable and to meet regular income needs the investors might not opt for the Systematic Withdrawal Plan (SWP) henceforth as in SWP, the gains will still be taxed and therefore may not help much in reducing tax liability.

Taxation on Balanced Mutual Funds

Balanced funds are broadly of two types :

Equity oriented balanced funds : Major portion of fund portfolio consists of equities, at least 65%, and rest in debts. Aim here is to minimize risk on investment. They are taxed as applicable on debt mutual funds.

Debt oriented balanced funds : Major portion of fund portfolio consists of debt and rest in equity. Aim here is to increase return on investment. They are taxed as applicable on debt mutual funds.

However, most of the balanced funds are equity-oriented hybrid funds that invest at least 65% of their assets in equities. This is why their tax treatment is exactly the same as equity funds.

Summary of Tax on capital gain from mutual funds.

Capital Gain taxation on different types of mutual funds

Type

Short-term capital gains tax

Long-term capital gains tax

Equity mutual funds

15%

10% without Indexation

Balanced mutual funds

15%

10% without indexation

Debt mutual funds

As per tax slab

20% after Indexation

How are SIPs taxed?

An SIP is method of investing a fixed amount in a mutual fund in a periodic manner. An SIP can be fortnightly, monthly, quarterly or yearly. Gains made from SIPs are also gains from mutual funds and taxed as per the type of mutual fund and the holding period.

For the purpose of taxation, each individual SIP is treated as a fresh investment and gains on it are taxed separately.

For example,

let’s suppose you begin an SIP of ₹ 10,000 a month in an equity fund for 12 months. Your each individual SIP is considered to be a fresh investment. Hence, after 12 months, if you decide to redeem your entire accumulated corpus (investments plus gains), all your gains will not be tax free.

Only the gains earned on the first SIP would be tax-free because only that investment would have completed one year. The rest of the gains would be subject to short-term capital gains tax.

Apart from these, there is also something called the Securities Transaction Tax (STT). An STT of 0.001% is levied by the fund company itself when you sell units of an equity fund or balanced fund. There is no STT on sale of debt fund units.

This is how gains from different types of mutual funds are taxed. As mentioned earlier, the longer you hold onto your mutual fund units, the more tax-efficient they become as tax on long-term gains is much lesser, even zero, than tax on short-term gains.

Tax strategies for Mutual Funds

Mutual funds can be tax-efficient investment avenues that can help reduce your tax burden and at the same time increase your wealth. Follow these strategies to save tax during investment in mutual funds :

Section 80C Tax benefit of investing in Equity mutual funds

Tax Planning or Income tax savings are an integral part of investment and overall financial planning that helps in a bid to maximize wealth. Tax planning in India involves the selection of the right tax saving instruments and making proper investments.

One of the key sections under which individuals can save tax is the Section 80C of the Indian Income Tax Act. Under this section, investments up to ₹ 1,50,000 per annum are eligible for deduction from your taxable income.

Only ELSS Mutual Funds offer tax benefits under section 80C of the Income Tax Act. As per this section, one can avail tax exemptions up to ₹ 1,50,000 by investing in ELSS funds.

ELSS is a dedicated mutual fund scheme that allows investors to save tax. It also provides an opportunity for long term capital appreciation. An ELSS fund manager invests in a diversified portfolio, predominantly consisting of equity and equity related instruments that carry high-risk and have the potential to deliver high-returns.

Read More : 15 things to know about ELSS funds

Consider the timing of fund purchases and sales relative to distributions

Year-end fund distributions apply to all shareholders equally, so if you buy shares in a fund just before the distribution occurs, you’ll have to pay tax on any gains incurred from shares throughout the entire year, well before you owned the shares. This could have a significant tax impact.

Selling a fund prior to the distribution will generally result in more capital gain or less loss than if you sell the shares after the distribution, if you only take into account market price changes reflecting the distribution. Selling shares after the distribution also usually will yield less gain or more loss.

If you are considering a purchase or sale around the time of a distribution, there are many other factors to consider, including the size of the dividend relative to the size of your expected investment and how the transaction may fit in your overall tax strategy. Consult a tax or other advisor regarding your specific situation.

Consider the fund’s turnover rate

Since a capital gain must be reported each time a purchase or sale of shares is made, funds that trade securities in and out very frequently may be apt to accumulate more taxable gains. Additionally, trading fees associated with this activity may also increase costs, cutting into net earnings.

Only those schemes which have consistently performed well in all kinds of markets can help you achieve your long-term goals and avoid being hurt from LTCG tax regime. These are the equity mutual fund schemes that have steadily performed better than their benchmarks and category average over three and five year periods.

Again, taxes are only one of many factors you should consider when choosing a mutual fund. Consult a tax or other advisor regarding your specific situation.

To look at some of the best performing funds from every category of mutual funds, check out Groww 30 best mutual funds to invest in 2018.

Happy Investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.