Thinking about investing in mutual funds? Knowledge of how different kinds of mutual funds are taxed is important, as it can help you and other potential investors decide what kind of investments to make and identify how to bring down the tax outgo, thereby increasing savings.
Well, among the various factors to consider in the selection process like returns yielded, credibility of mutual fund houses, investment style, fund management team, etc., the tax implications of mutual fund investments should not be overlooked. The income tax rules applicable on mutual fund gains come down to the kind of fund where investments are made — debt or equity — as well as the duration of investment. Here is a look at how the kind of fund determines the tax rate applicable:
How are Mutual Fund Investments Taxed?
Should 65% or more of the corpus of a mutual fund scheme be put into equities, for the purpose of taxation, it will be treated as an equity scheme.
In case of gains made from investments in an equity mutual fund scheme (ELSS mutual funds, tax saving mutual funds, etc.) held for more than 12 months, it will be considered as a long-term capital gain. Here, a 10% tax is applicable on gains surpassing Rs. 1,00,000 a year on equity investments.
If you wish to redeem your equity fund investments within 365 days, the returns or gains will be treated as short-term capital gains. Short-term capital gains are taxed at 15%.
For investments made in equity mutual funds before 31 January 2018, the gains till that date shall be considered as grandfathered, which means it will be tax exempt.
Dividends from equity mutual funds will not be taxed in the hands of the investors. However, dividends are paid after deducting a dividend distribution tax of 11.648% (which includes surcharge and cess).
Gains from debt funds that are sold after less than three years of holding will be treated as short-term capital gains for the purpose of taxation. Such gains get added to the income and will be taxed as per the applicable income tax slab.
If debt mutual funds are held for over three years, the returns are regarded as long-term capital gains for taxation purpose. The tax applicable will be 20% with indexation benefit.
Dividends from debt mutual funds will not be taxed in the hands of the investors. However, dividends are paid after deducting a dividend distribution tax of 29.12% (which includes surcharge and cess).
Arbitrage mutual funds that park money into arbitrage opportunities in cash and derivative sections of the equity markets, for the purpose of taxation, will be treated as equity funds.
Tax Saving Options under Equity Investments
Investments made toward ELSS mutual funds or tax saving mutual funds qualify for tax deduction under Section 80C of the Income Tax Act, 1961. The maximum tax deduction that can be claimed under this section for investments in ELSS mutual funds or tax saving mutual funds is Rs. 1,50,000.
Given that such schemes mostly invest in equity, the risk that you, the investor, take on is higher. However, ELSS mutual funds or tax saving mutual funds can reward you with higher returns for the extra risk. Such funds are a suitable option for investors with a high-risk appetite and who would like to park funds for a period of five to seven years. An essential point to be noted is that ELSS mutual funds come with a lock-in of three years. This means that the gains on ELSS mutual funds will be regarded as long-term gains and therefore will be subject to long term capital gains tax of 10%.
Now that you know all there is about the taxes applicable on different mutual funds, make this a factor under consideration while picking a plan to invest in. It is advisable to stay invested for the long term since the tax implications are lesser. Also, if the intent is to save on tax, you can consider going for tax saving mutual funds or ELSS mutual funds since you can claim tax deduction up to Rs. 1,50,000 under Section 80C on the investments made. Tax can affect your gains significantly, hence, make sure to factor this in while assessing which type of mutual funds to invest in.
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