Mutual Funds & Taxation – Everything You Need To Know
Mutual Funds, being investment instruments, naturally operate with the objective of generating profits. And as anyone familiar with basic economic principles would know, profits/gains (or income) attract taxes. Yes, there’s no escaping them regardless of where you generate your income from. In the case of mutual funds and taxation, your profits are taxed under both taxable income and also as realized capital gains, which operate a little differently.
Why is it important for investors to know about taxes? Needless to say, those who intend to file their income tax returns by themselves must have a thorough understanding of taxation. But even for those who plan to get their tax returns filed by a professional, having an understanding of taxes is beneficial. Financial planning, after all, involves estimating your future gains so that you can align your current plans. Your choice of investments, your quantum of investment, and whether you should even stay or exit an investment - all determine how much taxes you may pay in the long run.
The amount of mutual funds taxation you are subjected to depends on:
- The duration for which the investments are held,
- Your income-tax bracket,
- Type of mutual funds,
- Presence of dividend.
Principles of progressive taxation mean that long-term investments and lower income-tax brackets generally attract lower tax rates. In India, investors involved in such investments file their tax returns under the ITR-2 form. Let’s look at the various taxes that you, as an investor, must be aware of.
Capital Gains Tax
When investors earn profits by selling securities at higher prices compared to the purchase price, these profits are subject to Capital Gains Tax. Now, one might think that investing in mutual funds does not amount to trading securities. But even these indirect investments via mutual funds are not exempt from capital gains tax.
The amount of realized capital gains that are taxed depends upon the duration for which the stocks were held and whether the fund is an equity fund or a debt fund.
- Short-term Capital Gains Tax
Equity mutual funds taxation: When stocks of listed companies are held for less than 12 months, the capital gains realized are classified as short-term capital gains (STCG). The taxes on these is 15% of the realized capital gains, and the same therefore applies to equity mutual funds.
For Debt mutual funds taxation, though, the STCG depends on the income tax slab of the investor. For NRI investors, a TDS of 30% is applied at the time of sale.
- Long-term Capital Gains Tax
Equity mutual funds taxation: When stocks of listed companies are held for longer than a year, your realized profits are termed as long-term capital gains (LTCG). These are subject to a tax of 10%, after your first Rs 1,00,000 in profits.
What about debt mutual funds taxation on LTCG, you ask? For debt funds that are held for longer than 3 years, the realized profits are treated as long-term capital gains and are taxed at 20% after indexation benefits and at 10% without indexation.
As an example, to calculate capital gains on equity funds, assume:
- 10 was the hypothetical cost of sale (expense ratio, brokerage, etc.),
- Rs 5 was the cost of acquiring the fund, and
- 100 was the asset value at the time of sale,
Then the capital gains would be Rs. (100 - 10 - 5) = Rs. 85.
When it comes to long-term investment in debt mutual funds, we also need to understand indexation. This is important because we need to adjust the purchase price of an asset to account for inflation.
Consider an example where you buy debt mutual funds at Rs. 100 and then make the sale after 4 years at Rs. 140. This would mean that your capital gains is Rs. 40. But you do not have to pay taxes on the entire amount because you need to account for inflation as well. For this, you will need to find the 'indexed purchase price which is essentially the value of the purchase price when adjusted for inflation. Therefore, the original purchase price is adjusted for inflation by multiplying it with the ratio of CII in the year of sale to that in the year of purchase.
Here, CII is the Cost inflation Index, a figure that is issued by the government every year and which is 75% of the average rise in CPI (Consumer Price Index), a measure of inflation. So if the (hypothetical) CII at the time of purchase is 200 and at the time of purchase it is 250, then you would need to multiply 100 (the original purchase price) with (250/200), which reflects the purchase price of your asset after taking inflation into account.As a result, you would be taxed on your actual capital gains, which would be Rs. (140-125) = Rs. 15.
In the case of unlisted companies, the taxation criteria are different. Short-term capital gains are those that are realized in less than 36 months, while long-term capital gains are those that are realized in over 36 months and are taxed at 10%.
Dividend Distribution Tax
Companies distribute their after-tax profits as dividends among their shareholders. The dividend distribution tax is levied on companies declaring these dividends to their shareholders.
Companies in India had to pay DDT at 15%, but the effective tax rate amounted to 20.56% due to surcharge and cess. However, the recent Budget 2020 announced the removal of the dividend distribution tax.
Best Practices for Tax Savings
But how can you navigate mutual fund investments if you want to save taxes as well? Section 80C of the Income Tax Act specifies expenditures and investments that are exempted from the Income Tax. According to this clause, a maximum of Rs. 1.5 lakh can be deducted every year from an investor’s total taxable income, provided they invest in some specific instruments.
Mutual fund schemes specifically designed for such tax advantages are called Equity Linked Savings Schemes (ELSS). These schemes invest a major portion of their corpus into equity or equity-related instruments. They have a mandatory lock-in period of three years, and the profits from them would be classified as Long-Term Capital Gains, taxable at 10%. Download the Glide Invest app right now to invest upto Rs. 1,50,000 in ELSS funds to save tax.
In addition to this, other instruments that allow tax benefits under Section 80C include the National Savings Certificate (NSC) and the Public Provident Fund (PPF).
Another approach can be to try and avail LTCG benefits by selling equity funds at the minimum after a year and in case of debt funds, after 3 years. This would lead to tax savings because of LTCG benefits.
As investors, being informed of tax laws, rates, and best practices isn’t just a desirable position to be in. It’s crucial for navigating investments, expenditures, and savings and striking a fine balance between them. Understanding taxation and exploring the various types of financial instruments available would help you zero in on the schemes that would best align with their goals. Is there anyone who’d rather not want to do this?
Start investing in ELSS funds through the Glide Invest app now and save tax. Remember money saved is money earned!