As long as there is income, there is tax. Taxes can be minimized but not escaped. The Mutual funds returns are taxed under the head 'Income from Capital Gains.' Capital gains can be classified as long term or short term capital gains based on the investment holding period. Capital gains tax varies according to the holding period and type of mutual fund.
Holding period is the period from the date of purchase of mutual fund units till the day you sell them. Holding periods can vary depending on the mutual fund type. The gains or profit earned during the holding period is called as capital gains. Capital gains can be classified as Long term capital gains and Short term capital gains according to the holding period. The below table will show the short and long term for different type of mutual funds
|||Long Term Capital Gains||Short Term Capital Gain|
|Equity Mutual Fund ||Less than 1 year ||1 year or more|
|Debt Mutual Fund||Less than 3 year||3 year or more|
Mutual fund units become more tax efficient as time passes by. Long term gains are taxed much lesser; sometimes completely tax free than short term gains.
Taxation of equity schemes
When at least 65% of the mutual fund is invested in equity or equity related instruments, it is classifies as equity scheme.
In equity mutual funds, the returns are considered as long term capital gains if the investment is held for one year or more. According to the present-day laws, such returns are tax exempt. But if the investments are redeemed in less than 12 months, then it is considered as short term capital gains and taxed at 15% flat.
Taxation of debt schemes
When less than 65% of the mutual fund scheme is invested in equities, it is classified as non-equity funds. A few examples would be debt mutual funds, gold funds, fund of funds etc.
When a non-equity mutual fund is held for 3 years or more, it is categorized as long term capital gains and taxed at 20% with indexation benefit. Indexation is the process of using a price index to inflate the cost of unit between the purchase year and selling year as compensation for inflation. This is done to reduce tax on fund profits.
When an investment is held for less than 3 years, the returns are classified as short term capital gains. They are added to the income of the person. They are then taxed according to the income tax slab of the investor.
Taxation of hybrid schemes
How taxation works with SIP?
Most of the investors these days choose SIP route to invest into different mutual fund schemes and it is very important to understand how taxation works in this case. In Systematic Investment Plan (SIP), a certain number of units are purchased every month or quarter and the period of holding has to be calculated individually for each purchases. Each individual SIP instalment is considered as fresh investment.
Let's say your monthly SIP investment is ₹10,000 in an Equity mutual fund scheme from January 2018 to December 2022. The amount invested in January 2018 will complete one year in January 2019 and the amount invested in May 2018 will complete one year in May 2019 for taxation purposes. So, if you redeem your units in January 2018, only the gains earned on the first SIP will be tax free because it has completed 12 months. The rest of the gains will be conditional to short term capital gains tax.
Let's say your monthly SIP investment is ₹10,000 in a Debt mutual fund scheme from January 2018 to December 2022. The amount invested in January 2018 will complete 3 year in January 2021 and the amount invested in May 2018 will complete one year in May 2021 for taxation purposes. So, if you redeem your units in January 2021, only the gains earned on the first SIP will be subjected to long term capital gain,as it has completed 12 months. The rest of the gains will be conditional to short term capital gains tax.
Taxation on dividends
Dividends are received when investments are made under dividend option in mutual fund schemes. They are exempt from income taxes in both equity and debt schemes. Although dividends on equity funds are tax free in the investors' hands, mutual fund houses pays a Dividend Distribution Tax of 28.84% on dividends declared under debt schemes to the government.