Mutual Fund Taxation Decoded: What Investors Should Know

Investing in mutual funds is a popular way for individuals to build wealth over time. But did you know that mutual fund investments can do more than just grow your wealth? They can also help you save on taxes!

Mutual funds go beyond diversification, professional management, and returns; they are also one of the smart tools for tax optimisation. Whether you're a seasoned investor or just starting out, understanding the taxation applicable to different mutual funds can give you an edge in planning your financial future.

Let’s understand the taxation of mutual funds, from Equity-Linked Savings Schemes (ELSS) to the indexation of debt funds.

1. Equity-Linked Savings Schemes (ELSS): Tax Deduction Under Section 80C

One of the tax-saving options in mutual funds is Equity-Linked Savings Schemes (ELSS). These funds primarily invest in equities and other equity-related instruments, offering tax-saving opportunities and potential for wealth creation.

• Tax Deduction: Investors can claim a tax deduction of up to ₹1.5 lakh in every financial year under Section 80C (as per Old Regime) of the Income Tax Act, 1961.
• Lock-In Period: ELSS funds come with a mandatory lock-in period of three years, the shortest among all tax-saving instruments available under Section 80C.
• Capital Gains (Before 23rd July 2024): Long Term Capital Gains exceeding ₹1 lakh in a financial year are taxed at 10% without indexation benefits, while gains up to ₹1 lakh remain tax-free.
• Capital Gains (On or After 23rd July 2024): Long Term Capital Gains exceeding ₹1.25 lakh in a financial year are taxed at 12.5% without indexation benefits, while gains up to ₹1.25 lakh remain tax-free.

Why ELSS? ELSS combines tax savings with the potential for returns from equity investments, making it a preferred choice for many investors.

2. Equity Mutual Funds

Equity mutual funds, which allocate at least 65% of their portfolio to equities, offer tax treatment to encourage long-term investments.

• Short-Term Capital Gains (Before 23rd July 2024): Gains on units held for less than 12 months are taxed at 15%.
• Short-Term Capital Gains (On or After 23rd July 2024): Gains on units held for less than 12 months are taxed at 20%.
• Long-Term Capital Gains (Before 23rd July 2024): Gains on units held for more than 12 months are tax-free up to ₹1 lakh per financial year. Gains exceeding ₹1 lakh are taxed at 10% without indexation.
• Long-Term Capital Gains (On or After 23rd July 2024): Gains on units held for more than 12 months are tax-free up to ₹1.25 lakh per financial

Takeaway: The LTCG tax structure encourages investors to stay invested in equity mutual funds for the longer run.

3. Debt Mutual Funds

Debt mutual funds invest in bonds, government securities, and money market instruments. Their tax structure differs from equity mutual funds:

Tax Treatment:

• Short-Term Capital Gains (Before 23rd July 2024): Gains on units held for less than 36 months are taxed as per the investor's income tax slab rate.
• Short-Term Capital Gains (On or After 23rd July 2024): Gains on units held for less than 24 months are taxed as per the investor's income tax slab rate.
• Long-Term Capital Gains (Before 23rd July 2024): Gains on units held for more than 36 months are taxed at 20% with indexation.
• Long-Term Capital Gains (On or After 23rd July 2024): Gains on units held for more than 24 months are taxed at 12.5% without indexation.

Indexation Advantage

One of the advantages of debt mutual funds is the indexation benefit. It adjusts the purchase price of the investment for inflation, effectively reducing the taxable gains. For investors with a low to medium -risk appetite and a long-term investment horizon, debt mutual funds offer a tax-efficient way to generate returns.

How it works: If inflation rises, the purchase price (after indexation) increases, which reduces the taxable capital gains.

Why Debt Funds? They are ideal for investors looking for returns with lower risk and tax efficiency over a long-term horizon.

4. Dividend Income from Mutual Funds

Dividends received from mutual funds were previously tax-free in the hands of investors, but with the abolition of the Dividend Distribution Tax (DDT) in 2020, dividends are now taxable as per the investor's applicable income tax slab rate.

Tax Deduction at Source (TDS): For dividends exceeding ₹5,000 in a financial year, mutual funds deduct 10% TDS. For non-resident investors, the TDS rate is 20% + 4% Health & Education cess.

Key Insight: Dividend income should be factored into your overall tax planning to avoid surprises during tax filing.

5. Systematic Investment Plans (SIPs)

Systematic Investment Plans (SIPs) are a popular way to invest in mutual funds, giving investors the opportunity to contribute a fixed amount regularly.

Equity SIPs: Each SIP instalment is considered a separate investment for tax purposes.

• Long-Term Capital Gains (Before 23rd July 2024): Gains on SIP units held for more than 12 months are tax-free up to ₹1 lakh per financial year. Gains exceeding ₹1 lakh are taxed at 10% without indexation.
• Long-Term Capital Gains (On or After 23rd July 2024): Gains on SIP units held for more than 12 months are tax-free up to ₹1.25 lakh per financial year. Gains exceeding ₹1.25 lakh are taxed at 12.5% without indexation.
• Short-Term Capital Gains (Before 23rd July 2024): Gains on SIP units held for less than 12 months are taxed at 15%.
• Short-Term Capital Gains (On or After 23rd July 2024): Gains on SIP units held for less than 12 months are taxed at 20%.

Why SIPs?

SIPs enable rupee cost averaging, long-term wealth creation, and structured tax planning.

Now let’s understand the applicable tax brackets based on the period of holding mutual funds, for FY 24-25 and onwards, with the help of this explicit table -

Key Takeaways

• ELSS: Best for tax-saving with equity exposure.
• Equity Funds: tax structure for long-term gains.
• Debt Funds: Benefit from indexation for long-term investments.
• SIPs: Tax-efficient and disciplined investment approach.
• Dividends: Taxed as per the investor's slab rate.

Wrapping up

Investing in mutual funds not only offers opportunities for wealth creation but also allows investors to optimise tax efficiency. Whether you want to save taxes through ELSS, benefit from indexation in debt funds, or grow wealth systematically through SIPs, mutual funds cater to diverse financial goals.

Remember: Always consult a financial advisor or tax professional to tailor your investments for maximum tax efficiency and alignment with your financial objectives.

Smart investing isn't just about returns-it's also about minimizing tax liabilities.

Above article is authored by Quantum.

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