How are Returns from Mutual Fund Investments Taxed?

Published On: 24-Apr-2020

While you are creating an investment portfolio, you must not overlook the tax incidence of different investment options, as the different rates of taxation applicable to various investments may make such investment options attractive or otherwise. For example, you may consider tax-free bonds giving a yield of 6% per annum as low-yielding investments as compared to bank fixed deposits giving 7% interest. 

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However, when you compare the post-tax returns with tax rate assumed to be 30%, the tax-free bonds seem better investment option with 6% post-tax returns as against 4.9% post-tax returns by bank FDs. As such, it becomes vital for you to take cognisance of the tax incidence on the investment returns, and make an informed decision. Staying aware of the tax laws in respect of your investments will also help you ensure tax compliance. This article will discuss the tax laws governing your investments in mutual funds. 

When are you required to pay taxes?

Unlike the interest income from fixed deposits, for which you may need to pay tax on the accrual basis, you are only required to pay tax on mutual funds once you redeem your investments and realise your profits from the investments in mutual funds. 

However, you must note that the switch transactions are also treated as redemption from one mutual fund scheme and an investment in another scheme. As such, you must calculate tax even in case of switch transactions.

Categorisation of Mutual Fund Taxation 

Depending upon the type of the investment portfolio maintained by the mutual fund schemes, funds may be categorised into two categories for tax laws:

  1. Equity-oriented Funds – As per the tax laws, equity-oriented funds are such funds which invest 65% or more of their net assets in listed equity securities of domestic companies. Other than Equity Oriented Funds – This is the residual category, and all other mutual fund schemes other than equity-oriented mutual fund schemes are categorised here. All the Fund of Funds (FoFs) (except FoFs further investing in pure equity ETFs) are also classified under this category only, even if they may be investing in other equity-oriented funds. 

The categorisation of Capital Gains

As per the Income-tax laws, Capital gains may be classified into two categories depending upon the holding period of the mutual fund investments:

  1. Short Term Capital Gains (STCG) – It refers to the returns from investments that you hold for a relatively short period. Such a period has been specified differently for different investments under tax laws. For example, in case of equity-oriented mutual fund schemes, such a period is less than 12 months, while in case of other mutual fund schemes, such a period is less than 36 months.

  2. Long-Term Capital Gains (LTCG) – If you have stayed invested in the mutual fund investments for longer than the specified period as mentioned above, the gains from such investments will be considered as LTCG. 

Applicable Tax Rates for Capital Gains from Mutual Fund Investments

As per the prevailing tax laws, the following tax rates are applicable for capital gains from mutual fund investments:

  1. Equity Oriented Funds – STCG from such funds are taxed at 15% (plus applicable cess and surcharge), while LTCG is taxed at 10% (plus applicable cess and surcharge). The investors may also avail an exemption of up to Rs. 1 lakh a year in respect of LTCG from equity shares and equity-oriented mutual funds, taken together. Capital gains in both the cases, whether LTCG or STCG, may be calculated as the difference between the redemption value and the amount invested. Investors are not eligible for indexation benefit in the case of LTCG from equity-oriented funds. 

  2. Gains from Other Mutual Fund Scheme – STCG from such funds are taxed at the regular tax rates, as applicable to the investor. On the other hand, LTCG from such funds is taxed at 20% (plus applicable cess and surcharge) with indexation benefit. Indexation benefit allows the investors to adjust the investment cost with the inflation index, as notified by the Govt. every year based on prevailing inflation. As such, LTCG is calculated as the difference between the redemption value and the indexed investment cost instead of the actual amount invested as in the case of STCG. Accordingly, the effective tax incidence is even lesser than the applicable tax rate of 20%. 

Taxation of Dividend Received from Mutual Funds

If the investors have invested in the dividend plan of the mutual fund schemes, they may be receiving dividend income directly in the bank accounts apart from the appreciation in the fund NAV (Net Asset Value). Such dividend income is exempt in the hands of the investor. However, the mutual funds are liable to pay Dividend Distribution Tax as per the rates specified in respect of such dividend, which is deducted from the fund NAV. The tax on dividend income is also indirectly borne by the investor only in terms of reduction in fund NAV.

Take an informed decision for a tax-efficient financial plan. Happy investing!

Note: The tax provisions, as mentioned in the article, are updated as per the Finance (No. 2) Act, 2019. However, the tax incidence will be as per the prevailing tax laws as on the date of redemption of the mutual fund units and not as per the tax laws prevailing on the date of investment.

Disclaimers: The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. In view of the individual nature of the tax consequences, each investor is advised to consult his or her or their own tax consultant with respect to specific tax implications arising out of their participation in the Scheme. Income Tax benefits to the mutual fund & to the unit holder is in accordance with the prevailing tax laws/finance bill 2020. Any action taken by you on the basis of the information contained herein is not intended as an offer or solicitation for the purchase and sales of any schemes of UTI mutual Fund. Please read the full details provided in SID and SAI carefully before taking any decision.

UTI AMC Ltd is not an investment adviser, and is not purporting to provide you with investment, legal or tax advice. UTI AMC Ltd or UTI Mutual Fund (acting through UTI Trustee Company Pvt. Ltd) accepts no liability and will not be liable for any loss or damage arising directly or indirectly (including special, incidental or consequential loss or damage) from your use of this document, howsoever arising, and including any loss, damage or expense arising from, but not limited to, any defect, error, imperfection, fault, mistake or inaccuracy with this document, its contents or associated services, or due to any unavailability of the document or any part thereof or any contents or associated services