Why is Mutual Fund taxation important?
The very basic reason why a person looks to invest across various asset classes is to get better returns than traditional methods of investments and to have gained on the capital invested (called a capital gain).
But one thing that bothers an investor is the tax that is being applied to these investments. Investors are often worried and confused about the amount of tax they have to pay mainly because of a lack of knowledge and understanding of the taxation in the investments.
In this article we will try to understand how does taxation in Mutual funds works, what are short and long-term capital gains and how is dividend taxed.
Taxation on mutual funds depends on four factors
1. Type of investments
not all asset classes are treated in a similar way. Different asset classes attract different taxation. As a thumb rule debt mutual funds attract higher taxation as compared to equity mutual fund investments.
2. Holding period
two important concepts as far as holding period is concerned are Short term Capital Gain (STCG) and Long Term Capital Gain (LTCG) which defines the gains on the capital gain made in the short term and long term of the investment holding period. The definition of STCG and LTCG is different for different asset classes, namely Equity and Debt.
3. Amount of Capital Gain
Capital deployed is the amount that an individual has invested and the gains on the capital are the amount of capital gain. For example, if an investor has deployed 5,00,000.00 (invested amount) and the value after 2 years is 5,75,000.00 (current value of the investment) then the capital gain is 75,000.00 on the capital of 5,00,000.00
4. Tax Bracket
Taxation is not the same for every individual. Depending upon which tax bracket an investor falls into he has to pay the tax accordingly. Investors in higher tax brackets have to pay a higher amount of tax and hence should invest in a prudent way. An illustration of tax slabs for various age groups for individuals is shown below –
Understanding Short Term Capital Gain (STCG) and Long Term Capital Gain (LTCG) in Mutual Funds –
Taxation on the capital gain in mutual funds is different depending upon the type of mutual fund.
A fund is defined as an equity fund if at least 65% of its assets are invested in equity as an asset class e.g of an equity fund are Large-cap fund, Multi cap fund, and Balanced fund ( have 65% equity and 35% debt), arbitrage funds all fall under equity mutual fund category.
Whereas debt mutual funds have investments into debt or fixed income securities such as Government securities, corporate bonds, treasury bills, money market instruments, and other securities.
Definition of the short and long-term across equity and debt mutual funds depends on their holding periods. The table below clearly shows the different rates of taxes applicable depending upon the type of investments.
Equity Mutual Funds –
Any capital gain before one year is considered as Short Term Capital Gain (STCG) which is taxed at 15% (irrespective of the tax bracket in which an investor falls) and after one year is considered as Long Term Capital Gain (LTCG) and is taxed at 10% (irrespective of the tax bracket of the investor).
One important point to note here is that LTCG in Equity up to 1 lakh is tax-exempt which means that any capital gain that is realized after 1 year and is less than 1 lakh, no tax has to be paid.
For example if an investor invests 10,00,000 (10 lakh) and after one year the capital gain is 1,50,000 then he has to pay tax only on 50,000.00 not the entire 1,50,000.00 since 1,00,000.00 is exempted.
Debt Mutual Funds –
Any capital gain before 3 years is considered as Short Term Capital Gain(STCG) which is taxed as per the tax slab of the investor (marginal rate of interest) and after 3 years it is considered as Long Term Capital Gain (LTCG) and is taxed at 20% with indexation.
What Is Indexation?
In simple terms, indexation is taking into account inflation.
Let us understand inflation with an example. You have won a lottery of 1 lakh and have two options; either take the entire prize money today or after 1 year. It is a no-brainer that you will take the prize money today.
Why would you do so?
Because the value of 1 lakh today is higher than the value of 1 lakh after 1 year.
Inflation is the real culprit here.
The purchasing power of money decreases over a period of time due to inflation. The value of 1 lakh 20 years ago was much higher; you could end up buying a car with that money but not today.
Similarly, when you invest the returns that you have generated are after the inflation so if any investor has made 12% returns on his investments and inflation is 6%, his net returns (inflation-adjusted return) are only 6%.
LTCG in debt funds takes the same things into account.
In a very simple language, one can understand that in Debt mutual funds, the capital gain after 3 years (LTCG) is calculated after deducting the returns accounted for due to inflation hence the only net returns are taxable.
The table above shows the taxation in debt mutual funds as well as the indexation benefit. At the marginal rate of 30%, the investor has to pay a tax of 8,700.00 (which an investor would assume) but after 3 years it classifies as LTCG hence indexation comes into the picture.
After Indexation (color-coded yellow) shows the calculation once indexation is applied.
Cost Inflation Index (CII) is the inflation-adjusted purchasing price that is calculated in order to compute capital gains.
In the example above the actual amount invested was 1,00,000.00 but due to inflation the value of 1,00,000.00 invested 3 years back is now 1,29,000.00 (calculated by CII).
Inflation-adjusted cost price = CII for the year of sale/CII for the year of purchase)* Cost of Purchase
How is Dividend in Mutual Funds Taxed?
Not only capital gains but dividends in mutual funds are also taxed.
Earlier the dividends from equity mutual funds were tax-free but with recent changes in taxation dividends from both Debt and Equity Mutual Funds are taxed.
Dividends from equity mutual funds are taxed at 10% (16.95% with surcharge) and that of debt mutual funds are taxed at 25% (28.28%) with surcharge. The table below shows the taxation of dividends.
Taxation for SIP- Systematic Investment Plans is also taxed as per equity mutual funds. But one important point to note here is that since LTCG in equity kicks in after 1 year of investment and usually SIP is done on a monthly basis the first installment of SIP will be taxed under LTCG at the 13th month (it will complete 12 months), 2nd installment in 14th month and so on.