How Do You Earn Returns in Mutual Funds
Mutual funds are one of the most buzzing investment options as they help
you achieve your financial goals. Mutual funds are also tax-efficient
instruments. Investing in fixed deposits is a great disadvantage,
particularly if you fall under the highest income tax bracket, as the
interest is added to your taxable income and taxed at your income tax
slab rate. This is where mutual funds score better. When you invest in a
mutual fund, you get the benefit of expert money management and
tax-efficient returns.
How Do You earn Returns in Mutual funds
Mutual funds offer investors returns in two forms; dividends and
capital gains. Dividends are paid out of the profits of the company if
any. When the companies are left with surplus cash, they may decide to
share the same with investors in the form of dividends. Investors
receive dividends proportional to the number of mutual fund units held
by them.
A capital gain is the profit realised by investors if the selling
price of the security held by them is greater than the purchase price.
In simple terms, capital gains are realised due to the appreciation in
the price of the mutual fund units. Both dividends and capital gains are
taxable in the hands of investors of mutual funds.
Pro Tip: Invest in direct funds pay 0% commission and earn upto 1.5% extra returnsTaxation of Dividends Offered by Mutual Funds
As per the amendments made in the Union Budget 2020, dividends
offered by any mutual fund scheme are taxed in the classical manner.
That is, dividends received by investors are added to their taxable
income and taxed at their respective income tax slab rates.
Previously, dividends were tax-free in the hands of investors as the companies paid dividend distribution tax
(DDT) before sharing their profits with investors in the form of
dividends. During this regime, dividends (received from domestic
companies) of up to Rs 10 lakh a year were tax-free in the hands of
investors. Any dividends in excess of Rs 10 lakh per financial year
attracted dividends distribution tax at 10%.
Taxation of Capital Gains Offered by Mutual Funds
| Fund Type | Short-term capital gains | Long-term capital gains |
| Equity funds | Shorter than 12 months | 12 months and longer |
| Debt funds | Shorter than 36 months | 36 months and longer |
| Hybrid equity-oriented funds | Shorter than 12 months | 12 months and longer |
| Hybrid debt-oriented funds | Shorter than 36 months | 36 months and longer |
The short-term and long-term capital gains offered by mutual funds are taxed at different rates.
Taxation of Capital Gains of Equity Funds
Equity funds are those mutual funds whose portfolio’s equity exposure
exceeds 65%. As mentioned above, you realise short-term capital gains
on redeeming your equity fund units within a holding period of one year.
These gains are taxed at a flat rate of 15%, irrespective of your
income tax bracket.
You make long-term capital gains on selling your equity fund units
after a holding period of one year or more. These capital gains of up to
Rs 1 lakh a year are tax-exempt. Any long-term capital gains exceeding
this limit attracts LTCG tax at the rate of 10%, and there is no benefit
of indexation provided.
Taxation of Capital Gains of Debt Funds
Debt funds are those mutual funds whose portfolio’s debt exposure is
in excess of 65%. As mentioned in the table above, you get short-term
capital gains on redeeming your debt fund
units within a holding period of three years. These gains are added to
your taxable income and taxed at your income tax slab rate.
Long-term capital gains are realised when you sell units of a debt
fund after a holding period of three years. These gains are taxed at a
flat rate of 20% after indexation. Also, you are levied with applicable
cess and surcharge on tax.
Taxation of Capital Gains of Hybrid Fund
The rate of taxation of capital gains on hybrid or balanced funds is
dependent on the equity exposure of the portfolio. If the equity
exposure exceeds 65%, then the fund scheme is taxed like an equity fund,
if not then the rules of taxation of debt funds apply.
Therefore, it is essential to know the equity exposure of the hybrid
scheme you are investing in, if not then you might be in for a nasty
surprise on redemption of your fund units. The following table
summarises the rate of taxation of capital gains on mutual funds:
| Fund type | Short-term capital gains | Long-term capital gains |
| Equity funds | 15% + cess + surcharge | Up to Rs 1 lakh a year is tax-exempt. Any gains above Rs 1 lakh are taxed at 10% + cess + surcharge |
| Debt funds | Taxed at the investor’s income tax slab rate | 20% + cess + surcharge |
| Hybrid equity-oriented funds | 15% + cess + surcharge | Up to Rs 1 lakh a year is tax-exempt. Any gains above Rs 1 lakh are taxed at 10% + cess + surcharge |
| Hybrid debt-oriented funds | Taxed at the investor’s income tax slab rate | 20% + cess + surcharge |
Taxation of Capital Gains When Invested Through SIPs
Systematic investment plans (SIPs) are a method of investing in
mutual funds. They are designed in such a way that investors can invest a
small amount periodically in a mutual fund scheme. Investors are
offered the liberty to choose the frequency of their investment. It
can be weekly, monthly, quarterly, bi-annually, or annually.
You purchase a certain number of mutual fund units through every SIP
instalment. The redemption of these units is processed on a
first-in-first-out basis. Suppose you invest in an equity fund through
an SIP for one year, and you decide to redeem your entire investment
after 13 months.
In this case, the units purchased first through the SIP are held for
the long-term (over one year) and you realise long-term capital gains on
these units. If the long-term capital gains are less than Rs 1 lakh,
then you don’t have to pay any tax.
However, you make short-term capital gains on the units purchased
through the SIPs from the second month onwards. These gains are taxed at
a flat rate of 15% irrespective of your income tax slab. You will have
to pay the applicable cess and surcharge on it.
Securities Transaction Tax (STT)
Apart from the tax on dividends and capital gains, there is another tax
called the Securities Transaction Tax (STT). An STT of 0.001% is levied
by the government (Ministry of Finance) when you decide to buy or sell
mutual fund units of an equity fund or a hybrid equity-oriented fund.
There is no STT on the sale of debt fund units.
For more information on this, visit TAXAJ
Posted by Aashima
Team TaxaJ
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