Mutual funds and taxation: Everything you need to know

Mutual fund investments are one of the most popular investment choices as they help you to attain your financial goals in a convenient and diversified way. However, before you decide to invest in a mutual fund, it’s important to be well-versed with its taxation rules to make an informed decision. 

Mutual funds offer earnings in two forms – dividends and capital gains. Both capital gains and dividends are taxable in the hands of mutual fund investors. Read on to understand how mutual fund returns are taxed. 

Dividend taxation on mutual funds

According to the amendments in the Budget of 2020, dividends on any mutual fund must be taxed in the classic way. The dividends received must be added to your income and taxed as per your income tax slab rate. 

Earlier, dividend earnings were tax-free for investors while the companies had to pay the DDT (Dividend Distribution Tax) before sharing the profits with investors as dividend income. In this regime, an annual dividend income of up to Rs 10 lakh was tax free. Any dividend income exceeding Rs 10 lakh margin per year attracted a DDT at 10%. 

Capital gains taxation on mutual funds

The rate of taxation on mutual funds’ capital gains is based on two factors – the type of mutual fund you have invested in and your holding period. Holding period refers to the time period or duration for which you held the mutual fund units. Capital gains on holding the mutual fund units are categorised in the following manner – 

Fund typeLong-term capital gainsShort-term capital gains
Debt mutual fundsBelow 36 months36 months and above
Equity mutual fundsBelow 12 months12 months and above
Hybrid funds (debt concentrated)Below 36 months36 months and above
Hybrid funds (equity concentrated)Below 12 months 12 months and above

Note that the long-term and short-term capital gains on mutual fund schemes are taxed at distinct rates. 

Capital gains tax on equity mutual funds

As stated above, if you redeem your equity mutual fund units within a year, you realise a short-term gain. Such gains are taxed at 15% regardless of your tax slab. If you sell your equity units after a year, you register long-term gains. Here, no tax is charged if the long-term capital gains are up to Rs 1 lakh annually. However, if you register a gain of over Rs 1 lakh, then it attracts a tax of 10% without any indexation benefits. 

Capital gains tax on debt mutual funds 

As shown above, if you redeem your debt mutual fund units within three years, you register a short-term capital gain. Such capital gains are included in your income and taxed according to your tax slab. In contrast, debt funds register long-term gains when you redeem your debt fund units post holding them for over three years. Such gains are taxed at 20% with indexation benefits. 

Capital gains tax on hybrid mutual funds

The capital gain tax rate on the hybrid fund is based on your exposure to equity or debt. If in your hybrid mutual fund, the equity exposure surpasses 65%, then the scheme is taxed as an equity mutual fund. However, if it does not, debt taxation rules will apply. 

Ending note

So, the longer you hold your mutual fund investment, the greater the chances of it becoming tax efficient. Tax levied on long-term gains is comparatively lower than short-term capital gains tax. Also, if you are looking to reduce your tax liability, then you can consider investing in Equity-Linked Savings Scheme (ELSS) mutual fund. As per section 80C, you can save tax of up to Rs 1.50 lakh on ELSS investment.