Mutual Fund Taxation: A Detailed Guide for Equity & Debt Mutual Funds

Mutual fund taxation is one of the important aspects of mutual fund investment that every mutual fund investor should know about. Every mutual fund action incurs some tax implications for the investor. Knowing the exact taxation for mutual fund actins will help you in reducing the net tax outgo and enhance the returns. Today we will look at detailed tax rules for equity and debt funds and for both growth and dividend options.

Mutual Fund Taxation

Before we get into particulars of taxation, let’s understand the definition of Equity and Debt mutual fund. From a taxation point of view; Equity funds are the funds where the exposure to Indian Equity Stocks is more than 65%. And any fund with exposure of less than 65% to Indian Equity Stocks will be considered as a Debt Fund/Non-Equity Fund.

A summarized view of Mutual Fund Taxation is given below:

We will look at details of these taxation rules with calculation to understand how the tax will be calculated. If you want to calculate you can also use a mutual fund calculator to calculate the amount easily.

Long Term Capital Gains Tax

Long Term Capital Gain Taxation for both equity and debt fund has different rules. For Equity funds, the long term capital gain occurs when you redeem a fund after completion of the 1-year holding period. Whereas, for debt funds, the long term capital gain occurs when you redeem a fund after completion of a 3-year holding period.

Long Term Capital Gain on Equity Funds

Long term capital gain for equity funds is 10% on the capital gain over and above the gain of 1 Lakhs. For example:

If the investment amount = 1,00,000 ; The total current value after completion of 1 year = 3,00,000.

This makes the Long Term Capital Gain to be 2,00,000. Out of this capital gain of 2,00,000; 1 Lakh will be tax-free and on remaining 1,00,000 tax will be applicable at 10%.

Making the total tax payable to be 10,000 on this investment.

Long Term Capital Gain on Debt Funds

On the other hand, long term capital gain for debt funds is 20% with indexation. To calculate the benefit of indexation in case of debt funds, CII (Cost Inflation Index) is used. Indexation is used to adjust the purchase price according to inflation. Hence, in most cases, the purchase price increases after indexation; in turn reducing the overall profit.

Here’s how it works:

let’s say you purchase 1000 units at NAV of 20 on 1st April 2017. And the NAV after 3 years becomes 25 on 1st April 2020.

Capital Gain without indexation would be = 1000*(25-20) = 5,000

The calculation of capital gain with indexation will be as follows:

CII for the financial year 2017-18 = 272. CII for the financial year 2020-2021 = 301

Using these two figures, we will first adjust the purchase price to inflation. The inflation-adjusted purchase price = 20*(301/272) = 22.1324

With this NAV, the long term capital gain would be = 1000*(25-22.1324) = 2,867.65

On this capital gain, a 20% tax will be applicable. Hence the net tax payable = 2,867.65*20% = 573.5294

Short Term Capital Gain

Short Term Capital Gain for Equity funds will be applicable if the fund is redeemed before completion of the 1-year holding period. However, for the debt funds, short term capital gain will apply if the holding period is less than 3 years.

Short Term Capital Gain for Equity Funds

Short term capital gain tax on equity fund is applicable @15%. That means, if you redeem the equity fund before completion of one year holding period, you will have to pay a tax of 15% on the capital gain. Here’s an example:

Let’s say you invest 1,00,000 in an equity fund. After 6 months, this investment becomes 1,05,000. Now if you redeem this investment after 6 months, then the tax will be calculated as follows:

Short Term Capital Gain = 1,05,000-1,00,000 = 5,000

On this capital gain, tax payable = 5,000 * 15% = 750

Short Term Capital Gain For Debt Funds

Short term capital gain tax on debt fund is as per the tax slab of the investor. In simple words, if you incur any gain by redeeming debt funds before 3 years, you will have to pay tax according to your slab rate. That means if you fall in 10% tax slab, you will pay 10% on short term capital gain from debt funds. If your applicable tax slab is 30% then you will have to pay 30% on short term capital gain plus applicable cess.

For example:

If the investment in debt fund is 1,00,00 and after two years, it grows to 1,10,000. If you redeem it before completion of 3 year holding period, then the short term capital gain will be calculated as follows:

Short term capital gain = 1,10,000-1,00,000 = 10,000

Now based on your income tax slab you will have to pay tax on this gain. Let’s assume you fall in 10% slab then the tax to pay on this capital gain will be 10%.

Hence, Tax Payable = 10,000*10% = 1,000

Taxation of Dividend for Mutual Funds

In the Union Budget of 2020, the Dividend Distribution tax was demolished and the new rules for dividend options of mutual funds were introduced. According to the new rules the tax treatment of dividend payout and reinvest options changes as follows:

According to the new rules, the tax to be paid on dividends for both Equity and debt funds will be at the investor’s income tax slab rates. So if the investor’s income tax slab is 10%, the tax on dividend income will be 10% and similar rates based on individual investor’s tax slabs.

Every mutual fund will deduct the TDS @10% over the dividend paid in excess of 5,000 per annum. Hence, if your income is not taxable, you will either have to claim this amount while filing the tax or you will have to upload form 15G/15H on individual RTA’s websites to avoid TDS implications. You can upload these forms on KFintech, CAMS.

You can use these taxation rules to strategize your mutual fund entry and exit points and in turn to enhance the returns.