Everyone wants to save tax. But, not many are aware of the right investment channels to reduce tax burdens. Tax planning is a crucial component of managing one's finances. While the new tax regime introduced in the Union Budget of 2020 doesn't offer any tax savings, you still can enjoy the benefits of tax-reducing investments by opting for the old system, while paying your income taxes.

Mutual funds are one of the most tax-friendly investment options available to individuals. Here, in this guide, we discuss the different tax benefits of various types of mutual funds, helping you select the right MF that best suits your specific needs. 

Holding Period and Mutual Funds Taxation 

The period of investment in a mutual fund scheme is known as the holding period of the plan. The holding period plays a crucial role in determining the tax implications of your mutual fund investments. 

The holding period is categorised as:

  • Long-term investments 

Equity-oriented mutual funds that have a holding period of 12 months or more are considered as long-term investments. When it comes to debt funds, investments with a holding period of 36 months or more are considered as long-term investments. 

  • Short-term investments 

Equity mutual fund schemes that are held for less than 12 months are categorised as short-term investments. In the case of debt funds, if the holding period is less than 36 months, then the investment is considered short-term.

Refer to the table given below to find the classification of different types of mutual funds based on their holding periods:

Type of Fund Holding Period for Short-term Investments Holding Period for Long-term Investments
Equity-oriented funds

Lesser than 12 months

12 months and above
Balanced funds (equity-oriented)
Debt-oriented funds

Lesser than 36 months

36 months and above
Balanced funds (debt-oriented)

 

Taxation of Gains from Equity-Oriented Mutual Funds 

Mutual funds that allocate at least 65% of their funds in equities (stocks) are termed as equity-oriented funds. Long-term gains up to Rs. 1 lakh from equity-oriented mutual funds are tax-free. The minimum holding period to qualify for long-term capital gains is one year. Long-term gains above the Rs. 1 lakh mark are taxed at 10% plus 4% cess. 

If you sell units in your equity funds before the completion of one year, the gains are classified as short-term gains. It is taxed at a rate of 15% plus 4% cess.

If you receive any dividends from equity-oriented mutual funds, you don’t have to pay any taxes on it. The AMC (Asset Management Company) pays the DDT (Dividend Distribution Tax) that is charged at 11.648%. 

Taxation of Gains from Debt-Oriented Mutual Funds 

Mutual funds that invest in fixed-income instruments like government and corporate bonds, money market instruments, corporate debt securities are known as debt-oriented mutual funds. 

Short-term capital gains from debt funds (gains due to units sold before three years) are taxable. The taxation rate is as per the taxable slab of the investor. For instance, if you fall within the 10% income tax slab, then the gains you receive from short-term debt funds are taxed at 10% plus 4% cess. Long-term capital gains from debt funds are taxed at 20% plus indexation. 

Dividends from debt funds are tax-free for the investor. However, the AMC pays DDT at the rate of 29.120% before distributing the dividends earned to investors. 

Here’s a quick summary of taxation of equity and debt funds.

Income Type Equity Funds Debt Funds
Long-term Capital Gains 10% + 4% cess (If the long-term gain exceeds Rs. 1 lakh) 20% with indexation
Short-term Capital Gains 15% + 4% cess Applicable as per the income tax slab of the investor
Dividends Not taxable for the investor
DDT (Dividend Distribution Tax) charged for the AMC (Asset Management Company) 10% + 12% surcharge + 4% cess 25% + 12% surcharge + 4% cess

 

Taxation of Gains from Hybrid Mutual Funds 

In the case of hybrid funds that have an equity exposure of 65% or more, it is considered as an equity fund for taxation. Hybrid funds with an equity exposure of 65% or less are regarded as a debt fund for tax calculation. If a hybrid fund has equal exposure to debts and equity (50% each), then it's considered as a debt fund for taxation purposes.

Taxation of Gains from Balanced Mutual Funds 

The taxes imposed on a balanced fund depends on the type of fund. Balanced funds with higher equity exposure are considered as an equity fund for taxation. On the other hand, if a balanced fund has higher debt exposure, then it's considered as a debt fund for taxation.

Taxation of Gains from SIPs

SIP (Systematic Investment Plan) is a popular method of investing in mutual funds. In a SIP, investors spend a small sum periodically. The amount invested remains the same and investors can choose a payment frequency that is convenient for them. Investments can be made either – annually, semi-annually, quarterly, monthly or weekly.

The taxation of SIPs depends on the frequency of investment. Each SIP investment is treated as a separate investment, and the gains attract different taxes.

Let's illustrate the taxation of SIPs with an example. An investor invests Rs. 10,000 per month in an equity-oriented mutual fund for 12 months. At the end of twelve months, the investor decides to redeem the entire corpus – the investments as well as the gains made.

In this case, not all the gains are tax-free. Only the profits made from the first SIP are tax-free since the holding period for it is one year. All other benefits are subject to STCG (short-term capital gains) tax.

Taxation of Dividends Received from Mutual Funds 

Besides gains received from mutual funds, certain funds like the monthly income plan also offer periodic payouts to investors in the form of dividends. The good news here is that the dividends are not taxable in the hands of the investor. 

Instead, the AMC (Asset Management Company aka the Fund House) pays the DDT – Dividend Distribution Tax before paying dividends to investors. The AMC is charged DDT as per the following table:

Type of Scheme DDT Levied
Equity-oriented mutual fund schemes 11.64% (10% + 12% surcharge + 4% cess)
Debt-oriented mutual fund schemes 29.12% (25% + 12% surcharge + 4% cess)

 

STT (Securities Transaction Tax)

Besides the taxes mentioned above, mutual funds also attract another type of tax known as the STT. The Ministry of Finance levies an STT of 0.001% when you redeem units of an equity-fund or an equity-oriented hybrid fund. However, note that there is no STT for the sale of units of a debt fund. 

Taxation of the Principal Invested in Mutual Funds 

Besides tax benefits on the gains received from mutual funds, you can also enjoy tax exemptions on the principal invested in it. Investments of up to Rs. 1.5 lakhs in equity-linked saving schemes (ELSS) qualify for tax-exemption under Section 80C of the ITA. 

However, note that Rs. 1.5 lakh is the overall exemption allowed under Section 80C for an individual. It includes all eligible investments like EPF, PPF, NSC, life insurance premiums, ELSS mutual funds and more. 

EndNote

Be Aware of the Tax Implications of your Mutual Funds

When it comes to maximising the tax benefits of your mutual fund investments, the longer you hold on to it, the more tax-efficient they become. Taxes levied on long-term capital gains is significantly lower than that of short-term capital gains.

Make sure to be aware of the various tax implications, to get the most benefits out of your mutual fund investments.