Investing in mutual funds has become increasingly popular among Indian investors in the past few years. Mutual fund inflows have been creating new records every month. However, understanding mutual fund taxation in India is crucial to maximising your returns and ensuring compliance with tax regulations.

In this guide, we'll explore the nuances of mutual fund taxation in India, covering everything from short-term and long-term capital gains to the tax implications of different types of mutual funds.

Mutual Fund Taxation in India

Mutual fund taxation in India is governed by several factors, including the type of mutual fund, the holding period, and the investor’s tax bracket. The two main types of mutual funds, equity-oriented and debt-oriented, are taxed differently.

Taxation on Equity-Oriented Mutual Funds

Equity-oriented mutual funds are those where at least 65% of the fund’s portfolio is invested in equities or equity-related instruments. The taxation for equity-oriented mutual funds is as follows:

• Short-Term Capital Gains (STCG): If you sell your equity mutual fund units within one year of purchase, the gains are considered short-term. STCG is taxed at a flat rate of 20%, regardless of your income tax bracket.
• Long-Term Capital Gains (LTCG): If you hold the units for more than one year before selling, the gains are categorized as long-term. As of the latest tax regulations, LTCG up to ₹1.25 lakh per financial year is tax-exempt. Gains above this threshold are taxed at 12.5% without the benefit of indexation.

Taxation on Debt-Oriented Mutual Funds

Debt-oriented mutual funds invest primarily in fixed-income securities such as bonds, government securities, and money market instruments. The taxation rules for debt mutual funds differ from those of equity funds:

• Short-Term Capital Gains (STCG): For debt mutual funds, the holding period to qualify for STCG is three years. If the units are sold within three years, the gains are added to the investor's income and taxed according to the applicable income tax slab.
• Long-Term Capital Gains (LTCG): If the holding period exceeds three years, the gains are treated as long-term. LTCG on debt mutual funds is taxed at 12.5%.

Taxation on Hybrid Mutual Funds

Hybrid mutual funds, also known as balanced funds, invest in both equity and debt instruments. The taxation of hybrid funds depends on their equity exposure:

• Equity-Oriented Hybrid Funds: If the equity exposure is 65% or more, they are taxed like equity mutual funds.
• Debt-Oriented Hybrid Funds: If the equity exposure is less than 65%, they are taxed like debt mutual funds.

See Also: What Are Fixed Income Mutual Funds?

Taxation on Systematic Investment Plans (SIPs)

Systematic Investment Plans (SIPs) are a popular way to invest in mutual funds. The taxation of SIPs follows the same principles as lump-sum investments but with a crucial difference. Each SIP instalment is treated as a separate investment. Therefore, the holding period and taxation for each instalment are calculated individually.

For example, if you invest in an equity mutual fund through SIPs, each SIP instalment will be taxed based on the holding period of that particular instalment. This means some SIP units may qualify for LTCG tax, while others may fall under STCG.

Dividends from Mutual Funds

Before 2020, dividends from mutual funds were tax-free in the hands of investors, as the mutual fund house paid Dividend Distribution Tax (DDT). However, the 2020 Union Budget abolished DDT, and now, dividends are taxable in the hands of investors according to their income tax slab. Mutual fund houses are also required to deduct a 10% Tax Deducted at Source (TDS) on dividends exceeding ₹5,000 in a financial year.

Tax-Saving Mutual Funds (ELSS)

Equity Linked Savings Scheme (ELSS) is a type of equity mutual fund that qualifies for tax deductions under Section 80C of the Income Tax Act, 1961. Investments in ELSS up to ₹1.5 lakh per financial year are eligible for tax deduction. However, the returns from ELSS are subject to LTCG tax rules like other equity funds.

Tax Implications of Switching Mutual Funds

Investors often switch between mutual funds to optimize their portfolio returns. However, it's essential to understand the tax implications of such switches. In India, switching from one mutual fund to another is treated as a sale and repurchase. Therefore, any gains realized from switching funds are subject to capital gains tax based on the holding period and the type of mutual fund.

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