Taxes and Its Implications

In the previous chapter, we saw all the charges involved in mutual funds investment. From expense ratio to front-end and back-end loads, from upfront costs to hidden charges, we are now aware of all the charges that are levied on the mutual funds. In this chapter, we will learn another aspect that majorly affects the net return on your mutual fund investments, which is ‘tax’. We will understand how taxation affects your income earned from mutual fund investments.

“Hey! Mutual Fund X delivers 18% return per annum.”

“Did you hear, Mutual Fund Y declared so and so dividend?”

That is still fine, but what about the tax implication?

A rational investor wouldn’t just stop at finding out the fund’s performance but shall go one step beyond that and understand tax implications on such income.

Ranjit’s same uncle who ended up paying a high hidden cost while buying a house property in Pune made a similar mistake while investing. He did not evaluate his options. I guess it’s his habit to expend without research that lands him in such situations.

This time around, he ended up investing large sums into mutual funds that don’t offer tax benefits merely because they were providing a higher return of 22% on the investment. There was another option that provided an 18% return and offered tax benefits. Now his after-tax profit is less than the tax-free return of the tax-saving mutual fund.

Yeah! The tax implication can be significant depending upon the type of fund, tax slab applicable, etc. Therefore, it is important to understand the impact of taxation on mutual funds before beginning the journey.

So let us learn how the different types of income earned from mutual funds are taxed.

The Impact of Taxation

Mutual Funds offer slightly advantageous tax treatment compared to other investment assets. There are two types of incomes you can earn from investing in mutual funds. One is dividend income and the other is capital gains at the time of sale. While dividends are charged to tax as per the applicable tax rate slab of the investor, the capital gains are chargeable to tax based on the period of holding.

Short-term investment attracts income-tax @ 15% whereas long-term investments are taxed @10%. Whether an investment is long or short-term, is determined based on which type of fund it is and how long it was held by the investor. In the case of an equity or equity-oriented fund, it is considered a long-term investment if the holding period is more than 12 months and in the case of a debt fund, the holding period must be above 36 months to qualify as a long-term investment.

Types of Income Earned from Mutual Fund Investment

First things first! Let us become aware of the different types of income that are earned from your investment in mutual funds. Here they are:

• Dividend Income: According to the provisions of the Income Tax Act, 1961, as amended by the Budget of 2020, the income earned from dividends shall be taxed as per the slab rate applicable to the investor. Earlier, the dividend income was exempt from tax up to Rs. 10 Lakhs per annum, above which, it was taxed @ 10%.

• Capital Gains: When the sales proceeds received on the sale of mutual funds are higher than the amount invested, the difference is called capital gain. Based on whether the investment is long-term or short-term, capital gains are taxed.

Factors That Affect Taxes and its Implications

As we saw earlier, taxes on mutual funds can make a significant impact on your returns. Here are some factors that you can alter which can directly impact the tax liability arising from your mutual fund income.

• Period of holding: Let us understand the period of holding and its impact on the categorization of investment into short or long-term through the table below:

Note: The hybrid/mix funds with more than 65% equity component are called equity-oriented mix funds and those with more than 65% debt component are called debt-oriented mix funds.

• Type of Mutual Fund: Based on whether the mutual fund is equity or a debt fund, the short and long-term tax is decided. The following table portrays different rates of tax on different types of mutual funds.

Note: Cess and surcharge shall be added wherever applicable as per the provisions of the Income Tax Act, 1961.

Securities Transaction Tax (STT)

In addition to the above-mentioned taxes, one more tax is levied @ 0.001%. This tax is called securities transaction tax (STT). The Ministry of Finance, a department of the Union Government levies this tax at the time of buying and selling the mutual funds.

STT is levied only in the case of equity funds and not in the case of debt funds. If it is a mix/hybrid fund, an equity-oriented fund attracts STT whereas, in the case of debt-oriented funds, there is no STT.

Taxation in case of SIP

SIPs are systematic investment plans that promote investors to save a fixed amount every month to invest in mutual funds. When you invest in the SIP, every month a fixed sum is invested in a few units of the mutual fund. Each such unit is considered an individual investment asset and the period of holding is calculated for such units. And based on such a holding period, it is decided whether the investment is long-term or short-term.

If you sell different units at different intervals, then the first in first out method shall be used to ascertain the period of holding of the mutual fund units sold. This essentially means that the units you purchased first will be considered as being sold first. The other tax treatment in the case of SIP remains the same.

In nutshell

• There are two types of incomes an investor earns from mutual funds, (i) dividends and (ii) capital gains.

• Dividends are charged to tax as per the slab rate of the investor whereas capital gains depend on whether it is a long-term capital gain (LTCG) or short-term capital gain (STCG).

• Factors like the duration for which investment is held and the type of mutual fund affect the rate of tax charges on the capital gains.

• On equity-oriented funds, STCG is charged at 15%, and LTCG is charged at 10% beyond Rs. 1 Lakh. On debt-oriented funds, STCG is charged as per the slab rate in which investors fall whereas LTCG is charged at a 20% flat rate.

• STT at 0.001% is specifically levied on equity mutual funds and is charged at the time of buying and selling the mutual funds units.

• In the case of SIP, while other tax treatment remains the same, the duration of holding is determined based on the duration for which each unit was held. FIFO methods are used to determine the nature of the investment.