How mutual funds generate income/profit?
If you invest in mutual funds, there are two ways in which you will gain profits:
-
Capital gains: When you sell the unit at a price higher than the purchase price -
Dividends: A payout of a fund house’s accumulated profits to its investors.
Both these incomes will be taxed, however differently.
Tax on mutual fund capital gains
An investor becomes liable to pay capital gains tax at the time of sale or redemption of units. The tax is applicable only on the profit made on the investment, depending on two key factors:
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Type of mutual fund: Debt, equity or hybrid -
Holding period: Short term or long term
Capital gain tax on equity mutual funds
Equity mutual funds are those funds which have 65 per cent or higher allocation of assets to equity. Tax on sale of such funds is levied based on the holding period. If you sell the units of equity mutual funds within one year of purchase, gains made on the sale are taxable at the rate of 20 per cent. If the sale after one year of purchase attracts, 12.5 per cent of tax will apply on gains above Rs 1.25 lakh in one financial year.
|
Type of gain |
Holding period |
Tax rate |
|
Short term |
Up to 12 months |
20% |
|
Long term |
Over 12 months |
12.5% (on gains above Rs 1.25 lakh per financial year) |
Capital gain on debt mutual funds
Debt mutual funds, also known as income funds, invest in short and long-term securities issued by government, public financial institutions and companies. Rules are different for investments made on or after April 1, 2023 and those made after that.
For investments made on or after April 1, 2023
Under Section 50AA of the I-T law, gains from sale of debt funds are taxed according to the income tax slab rate without indexation. The holding period has no relevance for such MFs.
For investments made after April 1, 2023
Sale within two years of investment: According to tax slab
Sale after two years of investment: 12.5 per cent without indexation
Capital gains tax on hybrid mutual funds
The rate of tax on hybrid mutual funds varies according to fund type.
*Equity-oriented hybrid funds
Hybrid mutual funds that hold at least 65 per cent of their assets in equity and equity-oriented assets are equity funds.
|
Type of gain |
Holding period |
Tax rate |
|
Short term |
Up to 12 months |
20% |
|
Long term |
Over 12 months |
12.5% (on gains above Rs 1.25 lakh per financial year) |
*Debt-oriented hybrid funds
Hybrid funds that primarily invest in debt securities are taxed like debt funds.
For investments made on or after April 1, 2023
Under Section 50AA of the Income Tax law, gains from sale of debt funds are taxed according to the income tax slab rate without indexation. The holding period has no relevance for such MFs.
For investments made after April 1, 2023
-
Sale within two years of investment: As per tax slab -
Sale after two years of investment: 12.5 per cent without indexation
*Balanced hybrid funds
Balanced hybrid funds maintain a balance between debt and equity, with a range of 40-60 per cent allocated to stocks and an equivalent percentage allocated to debt instruments.
-
Sale within two years of investment: As per tax slab -
Sale after two years of investment: 12.5 per cent without indexation
Tax on mutual fund dividend
Under the current rules, the entire dividend is taxable for the investor under the head “income from other sources”. At the time of dividend distribution to the investor, the asset management company must deduct 10 per cent TDS under Section 194K, if the total exceeds Rs 5,000 in a financial year. The taxpayer can claim the already deducted TDS at the time of final tax payment and only pay the balance.
Takeaway for investors
Investors must understand that taxes significantly lower the overall profits made through investment in mutual funds. To understand the actual gains, it is important to make these calculations beforehand. This not only gives you a realistic picture of what to expect but also helps you prepare for tax filing.
FAQs
Are equity and debt mutual funds taxed differently?
Yes, equity and debt mutual funds are taxed differently. In case of debt mutual funds, gains are taxed as per the investor’s tax slab. But, capital gains tax on sale of equity mutual funds is determined by the holding period. In case of equity mutual funds, gains are considered long-term if the holding period is 12 months or more than that. The gains in this case are taxed at 12.5 per cent. In case of short-term holding of 11 months or less, the tax rate is 20 per cent.
How are gains calculated when units were bought in different instalments?
In such cases, gains are calculated using the first-in-first-out method.
Do switches, redemptions or SWPs trigger tax events?
Yes, all three occurrences are treated as tax triggers under the income tax law in India.
What should investors keep ready before filing the return?
Investors should keep ready the following documents and pieces of information before filing the return:
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Bank statements -
Capital gains statement -
Consolidated Account Statement -
Form 26AS -
Annual Information Statement -
Dividend/IDCW details -
PAN -
KYC details -
ELSS (80C) investment proofs -
Previous ITR (if applicable)