Mutual Fund Taxation

Investing in mutual funds can help you in wealth creation for the long term, but knowing how it is taxed and how much you are able to take home depends on how your gains are taxed. Mutual fund taxation in India has seen a fair amount of change over the past couple of years, especially after April 1, 2023, which makes it worth understanding properly before you plan your next investment or redemption.

In this blog, you will learn about mutual fund taxation, factors determining the tax, different kinds of funds and their taxes and taxation of dividends.

What is Mutual Fund Taxation?

Mutual fund taxation refers to the tax that you are liable to pay on the gains that you receive from your mutual fund investments. The gains or income come in two forms: Capital gains, a profit that you gain after selling assets for more than the purchase price, and dividends, which you receive as a periodic payout from the fund.

The applicable mutual funds tax rate depends on the type of fund you’re invested in, the nature of your income (capital gains or dividends) and how long you have held your units.

What Factors Determine the Tax on Mutual Funds?

Income tax on mutual funds is determined based on the following factors:

Types of Fund (Asset allocation)

Different types of mutual funds invest in different classes of assets and the tax rules change depending on which category the funds fall under. There are four types of mutual funds, such as equity-oriented mutual funds, debt mutual funds, hybrid mutual funds and international or global mutual funds. Each category has a specific taxation rule, hence it is important to know the type of mutual fund to know.

Holding Period

How long you hold your mutual fund units before redeeming them determines whether your gains are treated as long-term capital gains (LTCG) or short-term capital gains (STCG).

Date of Acquisition

For debt and certain other funds, the rules differ depending on whether units were bought before or after 1 April 2023.

Units bought in debt-oriented funds or other specified funds on or after 1 April 2023 fall under Section 50AA. These are taxed as STCG, no matter how long you hold them.

Units bought before 1 April 2023 still follow the old tax regime, where gains on units held for more than 24 months fall under LTCG and are taxed at a lower rate.

The Union Budget 2024 revised the equity gains tax rate, effective since July 23, 2024. The rate of tax applied depends on how long you held the investment and whether you sold it before July 23, 2024, or after it.

Nature of Income

Mutual fund gains can take two forms: capital gains and dividends.

Capital gain is the profit you make when you sell or redeem your mutual fund units at a price higher than the purchase price, whereas dividends are periodic payouts by the fund house out of the scheme’s accumulated profit. These two types of income are taxed under different rules.

Equity Mutual Fund Taxation (Equity-Oriented Mutual Funds)  (≥65% in Indian equities)

A mutual fund is classified as equity-oriented when it invests 65% of its total assets in the equity shares of domestic Indian companies. This category includes large-cap mutual funds, mid-cap mutual funds, multi-cap funds,  diversified equity funds, index funds tracking Indian indices, ELSS (tax-saving) funds, and equity-oriented hybrid funds.

Note: The ₹1.25 lakh exemption is a combined annual limit across all your long-term gains from equity shares and equity mutual funds; it isn't per fund.

Mutual fund taxation with example:

Say you invested ₹3 lakh in an equity mutual fund and redeemed it 18 months later for ₹3.8 lakh, earning a capital gain of ₹80,000. Since the units were held for more than 12 months, the gain qualifies as long-term capital gain (LTCG). If your total LTCG from eligible equity investments during the financial year is ₹80,000, it falls within the ₹1.25 lakh annual exemption limit, so no LTCG tax is payable. However, if your total LTCG for the year were ₹1.5 lakh, only the ₹25,000 exceeding the exemption limit would be taxed at 12.5%.

Debt Mutual Fund Taxation

Debt mutual funds primarily invest in fixed-income instruments such as government securities, corporate bonds, and money market instruments. Their taxation depends heavily on when the units were purchased.

Units bought on or after 1 April 2023: All gains, regardless of how long the units are held, are treated as short-term capital gains and taxed at the investor's applicable income tax slab rate under Section 50AA. There is no long-term classification and no indexation benefit available for these units.

Units bought before 1 April 2023: These units are treated a little differently. Depending on when you redeem them, these units can still qualify for long-term capital gains treatment, provided you've held them for the required period. Under the rules introduced by the Finance Act, 2024, such long-term gains are taxed at 12.5%, without the benefit of indexation.

Hybrid Mutual Fund Taxation

Hybrid mutual funds invest across both equity and debt instruments, and their tax treatment depends entirely on the fund's equity allocation.

• Equity-oriented hybrid funds (≥65% in domestic equity, such as many Aggressive Hybrid Funds): Taxed exactly like equity mutual funds, 20% STCG for units held up to 12 months, and 12.5% LTCG above ₹1.25 lakh for units held beyond 12 months.
• Debt-oriented hybrid funds (equity allocation below 65%, such as Conservative Hybrid Funds): generally taxed under the rules applicable to non-equity mutual funds. For units purchased on or after 1 April 2023, all gains are taxed at the slab rate irrespective of holding period. Units purchased earlier follow the pre-April 2023 debt fund rules described above.

International (Global) Mutual Funds Taxation

International mutual funds, like US-focused or global index feeder funds, invest mainly in overseas equities, so they don't meet the 65% domestic equity requirement. Because of this, they're generally taxed under the rules applicable to non-equity mutual funds.

• For units purchased on or after 1 April 2023, gains are taxed at the investor's slab rate, regardless of the holding period.
• No indexation benefit is available.
• The ₹1.25 lakh LTCG exemption applicable to equity funds does not extend to international funds.

Taxation of Dividends Provided by Mutual Funds

The Dividend Distribution Tax (DDT), which fund houses earlier paid on investors' behalf, has been abolished. Dividends declared by mutual funds are now taxed directly in the hands of the investor.

• Dividend income is added to your total income and taxed at your applicable income tax slab rate, under the head "Income from Other Sources."
• If the dividend (or IDCW) you receive from an AMC crosses ₹10,000 in a financial year, the AMC deducts 10% TDS under Section 194K before paying you, subject to applicable conditions. The deducted TDS can be claimed as a credit while filing the income tax return.
• Choosing the Growth option instead of the Dividend/IDCW option is a common approach some investors use to avoid periodic taxable payouts, though this depends entirely on individual cash flow needs and financial goals.

Conclusion

Understanding mutual fund taxation is an important part of sound financial planning. The tax payable on your investments is shaped by a few key factors: the type of mutual fund, the holding period, and the tax regulations applicable at the time of redemption.

Given that these regulations are revised periodically, staying informed can help investors anticipate their tax liability more accurately and avoid unexpected outcomes at the time of filing returns.

FAQs

Is tax payable on mutual funds every year?

Taxes are triggered in one of these specific instances. Tax on mutual fund gains is triggered when you are selling, redeeming, or transferring your units, not when you are only holding them. When it comes to dividend income, any dividends declared by mutual funds are added to your overall tax income and taxed according to your income tax slab.

Are mutual fund taxes deducted automatically?

Capital gains tax on mutual funds is generally not deducted at source for investors who are residents of India; you are required to calculate and pay it yourself while filing your income tax return. The exception is dividend income, where the AMC deducts TDS at source if your annual dividend from a single fund house exceeds ₹5,000. For NRI investors, TDS is typically deducted on capital gains and dividends, at rates specified under the Income Tax Act.

Does switching between mutual funds attract tax?

Yes. Switching from one scheme to another, even within the same fund house, such as moving from a Growth/IDCW option to a Dividend option, or from one equity fund to another, is treated as a redemption followed by a fresh purchase. This means capital gains tax applies on the switch, even though no money is withdrawn to your bank account.

What documents do I need for mutual fund tax filing?

To accurately report mutual fund income while filing your income tax return, it generally helps to have the following on hand:

• Capital gains statement
• Consolidated Account Statement (CAS)
• Form 26AS and AIS (Annual Information Statement)
• Account statement/transaction history
• Dividend statements
• Details of the brokerage or platform used
• PAN and AADHAAR
• TIS (Taxpayer Information Summary)

Does inflation affect mutual fund taxation in India?

Under the current tax rules, most mutual funds no longer get the benefit of indexation. This means tax is calculated simply on the actual purchase and sale price, without adjusting for inflation.

Do I need to report mutual fund investments in my income tax return even if I haven't redeemed them?

Capital gains only need to be reported in the year of redemption or switch. However, dividend income received during the year must be reported regardless of whether you've redeemed your units.