The Tax Implication of Investing in Mutual Funds

The primary goal of every investment is generally wealth creation. Mutual funds are one of the popular investment vehicle which can help investors to achieve  various financial goals. An important factor to consider when investing in mutual funds is the tax that would be applicable when you sell the units of the mutual fund scheme.

The Securities and Exchange Board of India (SEBI) establishes the guidelines for tax on mutual fund investments. The tax on mutual funds is based on the type of asset the fund focuses on and the holding period of your investment. Notably, the tax on mutual funds differs for equity funds and debt funds as well as for dividends and capital gains.

Before we discuss the taxation rules for mutual funds, it is important to know about the two main categories of mutual funds schemes i.e., equity funds and debt funds.

According to SEBI classification of mutual funds, an equity-oriented fund is a mutual fund scheme where at least 65% of its total assets are invested in equity shares of domestic companies. The gains/losses arising on the transfer of units of equity funds are classified as short-term/long-term capital gains, depending upon their period of holding. Notably, in the case of equity funds, a holding period of less than one year is considered short-term and holding period of greater than 1 year is considered long term.

Debt funds (i.e., a non-equity-oriented fund) invest in fixed-income securities such as bonds issued by the government and corporate, debt securities, money market instruments, etc., and carry a different tax rate from equity-oriented funds. Notably, in the case of debt funds, a holding period of less than three years is considered short-term

The rules for tax on mutual funds also differ on their holding periods, such as long-term and short-term investments, for equity funds and debt funds. The capital gains from the sell of mutual fund units are subject to capital gain tax on mutual fund investments. Capital gains are taxed at varying rates for equity funds and debt funds, and even the duration differs for both categories.

In the case of equity funds, Long Term Capital Gains (LTCG) are tax-free up to Rs 1 Lakh, whereas LTCG under debt funds are taxed at a flat rate of 20% with indexation benefits. Short Term Capital Gains (STCG) for equity funds are taxed at 15%, whereas, for debt funds, the STCG is added to the taxable income and is taxed as per the income tax slab of the investor.

Investors, must know how mutual funds are taxed. Here’s a table that will help you understand the tax implication of investing in mutual funds:

Note: Indexation is the adjustment in the purchase price of an investment to reflect the inflation impact on the purchase value. With indexation benefits, investors can lower the long-term capital gains and bear lesser tax liabilities.

There is a special category of mutual funds that offer tax benefits to investors – Equity Linked Savings Scheme (ELSS) also known as tax-saving mutual funds. ELSS funds have a lock-in period of 3 years and allows tax savings of upto Rs.46,800 for investors under the highest tax bracket.

Knowing the tax implications makes it simple to choose which mutual fund strategy is best for you. The tax implication on investment in a mutual fund scheme is the same whether you invest a lump payment or through a SIP. 

But despite the tax implications, mutual funds can help you achieve your financial goals with careful planning. The tax on LTCG is comparatively lower than the tax on STCG; thus, consider investing in mutual funds with a long-term approach. When calculating your mutual fund returns, carefully account for the applicable taxes.

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Mutual fund investments are subject to market risks read all scheme related documents carefully.