How Mutual Funds are Taxed - Mutual Fund Taxation

Unlike fixed return schemes with a maturity period where the interests received get added to the annual income and become taxable in case your net annual income falls under a tax bracket, you can manage mutual funds returns effectively and increase your returns by saving taxes. 

Before learning further about tax on mutual funds, it is important to know what are the different types of returns that an investor earns from mutual funds.

Key Highlights

• Tax Depends on the Holding Period and Fund Type
• Debt Funds are Taxed at Income Slab Rate
• SIP Investments are Taxed Unit-wise

Types of Returns on Mutual Funds

Mutual funds returns are generally of two types - Earnings from Dividends and Capital Gains. Subsequently, mutual fund taxation is also based on the type of return, i.e. the tax provisions for dividend earnings are different from those of capital gains. 

• Mutual funds might give you a bonus (dividend) from their profits. Under section 194k of the Income Tax Act, a small cut (10% TDS) is applied before you get your dividends, but only if the total dividend for the year is over ₹5,000. Later, you can get that 10% back when you file your taxes.
• How long you hold onto your MF units before selling matters when it comes to taxes. This period is "Holding Period." In India, the government encourages investors to hold onto their investments for a longer time. So, if you sell them after holding units for a shorter period (usually less than a year), you might have to pay more tax on your capital gain.

How are Mutual Funds Taxed?

Taxation on Dividends Received from Mutual Funds

Dividends paid to investors by Indian companies remained tax-free until March 31, 2020. Dividends are now taxable at the applicable slab rates, however, as a result of the Finance Act of 2020's introduction and repeal of the Dividend Distribution Tax (DDT), businesses that distribute dividends must deduct 10% of dividends over ₹5,000 in a fiscal year for Tax Deducted at Source (TDS).

Taxation on Capital Gains from Mutual Funds

As said, capital gains are broadly classified into short-term capital gains (STCG) and long-term capital gains (LTCG), so each type of mutual fund is taxed differently.

Note: In the new Budget for 2024, the taxes on mutual fund investments have changed. Now, if you redeem the units within a year, the tax rate is 20%, and if you sell after a year, the tax rate is 12.5%. Before this update, Debt Fund taxation changed in 2023. So Debt Funds are taxed based on your income slab, similar to Fixed Deposits. This eliminates the previous advantage of indexation for long-term gains. This change affects not only Debt Funds, but also Gold Funds, Hybrid Funds, and International Equity Funds.

Read More: Budget 2024 Highlights and Key Announcements

Taxation on Capital Gains from Investments made through SIPs

Systematic Investment Plans (SIPs) allow you to invest a small amount every month in a mutual fund scheme. They give you the flexibility of investment and offer to earn more returns from the power of compounding. With every SIP instalment, you are allotted certain mutual fund units. The period of capital gain is decided accordingly.

• For example, if you have invested every month for 12 months, and want to redeem all the units in the 13th month, the profits earned from selling the units allocated in the first month qualify for LTCG while the gains made from selling units allocated in the next 11 months are considered to be STCG.
• Additionally, if the first month's gain is up to ₹1.25 lakh, you do not have to pay any taxes. Whereas, gains of above ₹1.25 lakh are taxed at 12.5%.

Steps to Declare Mutual Fund Investments in ITR

When an investor earns a capital gain during the fiscal year, they must file either ITR-2 or ITR-3. Do remember these are filed for the year when an investor redeems their mutual fund units. If an investor has capital gains in a given year, they must file an ITR-2. Here are the steps to declare your mutual fund investments while filing ITR:

1. Login to the income tax website.
2. Choose ITR form, status, and year.
3. Select "Income Schedule" and "Schedule Capital Gains."
4. Report short-term or long-term gains (details vary).
5. Confirm schedules and preview return.
6. Provide details and validate ITR.
7. Verify ITR electronically or via ITR-V form.

Conclusion

Unlike the initial impression, understanding mutual fund taxation boils down to two key factors: holding period and fund type (equity or debt). While tax calculations can seem daunting, especially near tax filing deadlines, familiarising yourself with these basics gets you to make informed investment decisions and potentially maximise your returns. With proper planning and a grasp of the tax implications, mutual funds can be a powerful tool for achieving your financial goals.

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