Understand The Taxation on Mutual Funds Sales

Capital Gains on Sale of Mutual Funds

Mutual fund investment is a popular choice for many individuals who want to grow their wealth over time. However not everyone is aware of the tax implications that are applicable to mutual funds. 

That’s why we have curated this article explaining taxation on Mutual funds so you can plan your future investments wisely. 

Let’s get started! 

What Factors Determine Taxation on Mutual Funds?

Below are some of the factors that determine taxation on mutual funds. 

• Type of mutual fund

The type of mutual fund in which an investor invests significantly impacts taxation. For example, if you invest in an Equity Mutual Fund,  the tax treatment will differ from that of a Debt Mutual Fund, Hybrid Mutual Fund, etc. 

• Investor's holding period

The holding period refers to the time period between the purchase date and sale of mutual funds. This factor affects the taxation of capital gains to a great extent. 

• Dividend

Mutual funds sometimes distribute a portion of their profits to investors, known as dividends, which are subject to taxation. 

• Capital Gains

This happens when the value of the mutual fund shares increases, and you sell them for more than you bought. Simply put, if the overall value of a mutual fund goes up, your shares become more valuable, and by selling them at a higher price, you can make a profit.

How Profits are Generated In Mutual Funds

Profits or returns in Mutual Funds are generated in two different forms: 

• Dividends

These are portions of a company's profit shared with investors. When companies generate excess profits, they might distribute a part of these profits back to their shareholders as dividends. How many dividends an investor can get? It totally depends on how many shares of the mutual fund you own. 

• Capital Gains

This happens when the value of the mutual fund shares increases, and you sell them for more than you bought. Simply put, if the overall value of a mutual fund goes up, your shares become more valuable. By selling at a higher price, you can make a profit. 

Now, let’s see how tax is calculated on both Dividends & Capital Gains! 

How Tax Is Calculated on Dividends Offered by Mutual Funds

According to the Finance Act of 2020, the taxation of dividends from mutual funds underwent significant changes. One of them was the elimination of the dividend distribution tax. 

Before these changes, mutual fund companies were responsible for paying Dividend Distribution Tax (DDT) before distributing dividends to investors. This meant that investors didn't have to worry about paying taxes on their dividends until March 31, 2020.

However, with the removal of DDT, the responsibility for paying taxes on dividends shifted to the investors themselves. Dividends are now considered part of the investor's overall income and are taxed accordingly, based on their income tax bracket.

Additionally, a new rule regarding Tax Deducted at Source (TDS) on dividends was introduced. Asset Management Companies (AMCs) now deduct 10% TDS on dividends if an investor's total dividend income exceeds ₹5,000 in a financial year. Investors can claim this deducted TDS when filing their income tax returns. 

How Tax Is Calculated on Capital Gains Offered by Mutual Funds 

The tax rate on Capital Gains is affected by two factors, i.e, holding period and Mutual Fund type. 

Below are the categories that apply to capital gains. Both short-term and long-term are taxed at different rates. 

Taxation of Capital Gains Provided by Equity Funds

In equity funds, the majority (more than 65%) of the fund's total assets are invested in stocks of companies. 

When you sell your equity fund units within one year of buying them, the profit is considered a short-term capital gain (STCL), which is taxable at a rate of 15%, regardless of your income tax slab.

On the contrary, if you hold your equity fund units for more than one year, the profit is termed as a long-term capital gain (LTCL). The good news is that up to Rs 1 lakh of long-term capital gains in a year are tax-free. However, if your long-term capital gains exceed this limit, the amount above Rs 1 lakh is subject to a 10% tax without the benefit of indexation. 

Taxation of Capital Gains Provided by Debt Funds

Debt funds are primarily invested in fixed-income securities, with at least 65% of the portfolio allocated to debt exposure and no more than 35% to equity. 

Previously, long-term capital gains (LTCG) from debt funds were taxed at a rate of 20% with the benefit of indexation. This allowed investors to adjust the purchase price of their investment for inflation, ultimately reducing taxable capital gains.

However, as of April 1, 2023, a significant change in the tax treatment of debt fund capital gains came into effect. 

Debt fund capital gains will no longer receive indexation benefits. As a result, all gains from debt funds, whether short-term or long-term, will be treated as part of your taxable income and taxed at your applicable income tax slab rate.

Taxation of Capital Gains Provided by Hybrid Funds

The taxation of capital gains on hybrid funds varies according to the equity exposure of the fund's portfolio. 

• If it exceeds 65%, the fund scheme will be treated as an equity fund for tax purposes. 

• If the equity exposure is less than 65%, the taxation rules of debt funds will be applicable.

So, it's crucial to understand the equity exposure of the hybrid scheme you're investing in because it determines how your capital gains will be taxed.

Here’s a table summarizing the taxation of capital gains on mutual funds. 

Frequently Asked Questions (FAQs)

1. Can I avoid capital gains tax?

No, it's not possible to avoid capital gains tax, but yes, you can seek help from a KarrTax expert to learn strategies for minimizing the tax impact. 

1. Is it required to pay mutual fund taxes yearly?

No, taxes on mutual fund investments are not necessarily paid on a yearly basis. Instead, taxes become applicable when you redeem your mutual fund units or sell the scheme.