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The ABC of Taxation in Mutual Funds

Researching tax benefits on your mutual funds returns is often a head-scratching and thankless exercise. It’s a boring and highly effortful task, nobody enjoys doing.

But at the same time, there are no two ways about its importance as well. Having the knowledge of the benefits you are entitled to, can maximise your returns and save your hard earned money, from “those tax guys”.

Thanks to the growing popularity of Mutual Funds, the government has brought in legislation that exempts certain dividends and capital gains from tax. Any savvy investor should know how to take the maximum benefit of these exemptions to set up a tax-free source of income!

The major consideration while deciding taxability of mutual funds is the holding period. As you must be aware, this is the length of duration of your investment.

The following table will tell you how your mutual funds are taxed with respect to the holding period.

source

The holding period can be either short-term or long-term. Again, this depends on the type of mutual funds in question. For instance, for equity and balanced mutual funds, a holding period of 12 months or more is regarded as long-term. The same, however,  in the case of non-equity mutual funds, is 36 months.

Here’s what it effectively looks like:

Source: Relakhs.com

Now, let’s look at the taxation of short-term and long-term gains on different types of mutual funds:

  • Tax-saving equity funds: The Equity-Linked Saving Scheme (ELSS) is the most efficient tax-saving instrument, according to Section 80C of the Income Tax Act of 1961.

    With a lock-in period of 3 years, investing in ELSS can help you claim a tax deduction of up to Rs. 1.5L and save taxes up to Rs. 45k. Upon completion of the 3-year period, the long-term capital gains (LTCG) up to Rs. 1L are yours, completely tax-free. Anything in excess of that is taxed at a rate of 10%, with no indexation.

    (In case you weren’t aware, indexation factors the rise in inflation between the year you bought the funds and the year you sold them.

    Indexation allows inflating the purchase price of debt funds so as to significantly bring down the quantum of capital gains.)

  • Non-tax saving equity funds: LTCG on non-tax saving equity funds up to Rs. 1L are tax-free. Anything over that is taxed at 10%, without indexation.

    If you redeem the units before 12 months, the short-term gains will be taxed at the rate of 15%.

  • Debt funds: Talking about long-term capital gains on debt funds, they are taxed at a rate of 20%, after indexation.

Short-term gains, on the other hand, are added to your income. Then, they’re subject to short-term capital gains tax (SCGT), as per the tax slab you fall under.

  • Balanced funds: These are equity-oriented hybrid funds that invest at least 65% of the assets in equities. That is why their tax treatment is exactly the same as non-tax saving equity funds.
  • Systematic investment plans (SIP): An SIP is a method of investing a fixed amount in a mutual fund, periodically. It can be fortnightly, monthly, quarterly, or even yearly.

    Gains from SIPs are taxed depending on the type of mutual fund and the holding period. Each SIP is treated as a fresh investment and gains on it are taxed separately.

    For instance, say you begin a SIP of ₹10,000 per month, in an equity fund for a year. As you already know, each individual SIP is considered a fresh investment. So, after 12 months, if you decide to redeem your investments plus gains, you won’t get it all tax-free. Only the gains earned on the first SIP would be tax-free.

The reason being only the first investment would have completed a year. The rest would be subject to short-term capital gains tax.

Apart from these, you should also be aware of the Securities Transaction Tax (STT). An STT of 0.001% is levied by the fund company when you sell units of either an equity or a balanced fund. There is, however, no STT on the sale of debt funds.

To conclude, the tax-efficiency of your mutual funds depends highly on the time you stay invested in them. And knowing these crucial details will be important to make you Mutual Funds investment ready.

Author: Samant Sikka-Chief Dreamer & Founder, Sqrrl.in

This piece has been written by Samant Sikka, Chief Dreamer & Founder of Sqrrl – a personal finance, fintech venture targeted at young Indians helping them improve their relationship with money ultimately helping them Save, Invest & Prosper!!

Samant has been a student of financial markets & human behavior for 20+ years helping investors, institutions, and advisors. He has vast experience across Strategy, Sales, Business Development & Advisory Roles with stints at Axis Asset Management, Goldman Sachs, Franklin Templeton, AIG, and Darashaw & Company.

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