How are Equity Mutual Funds Taxed?

The number of investors turning to mutual funds has constantly been rising. A lot of people see investing in equity mutual funds as a method to generate high returns quickly. This however can turn out to be false, if you do not calculate your tax liabilities in advance. Different funds have different tax liabilities. Understanding mutual funds taxation can help you choose the most suitable fund as per your goals.

How do Mutual Funds in India Generate Returns?

If you understand equity mutual funds, you might also have an idea about how they work. The return of a mutual fund highly depends on its underlying asset class and its performance. The primary source of return is an appreciation of the value of these underlying assets while you hold them. This will also increase your net asset value.

Another method is when any of the underlying assets of these mutual funds declare bonus shares or dividends etc. Finally, the third step is when the asset management company sells any of the underlying assets after their value appreciates.

Factors Determining the Taxation of Mutual Funds

To understand tax on mutual funds, you also need to understand the factors that determine this tax liability. Essentially, there are four such factors:

1. Mutual fund type: There are primarily two types of mutual funds. Equity-oriented mutual funds and debt-oriented mutual funds.
2. Capital gains: When you sell a capital asset over its purchase price you make a profit. In tax terms, it is called capital gains.
3. Dividend: A dividend is the distribution of profits generated by a company which it gives to its shareholders.
4. Holding period: The time period starting from when you bought the funds and when you sell them off is the holding period.

Equity Mutual Funds Taxation 

If you hold your equity-oriented funds for a period longer than twelve months, you attract long-term capital gains on the same. Any holding period of less than twelve months is taxable as per short-term capital gains.

If you square off your equity mutual funds holding before twelve months, you are taxed at a flat 15%, irrespective of your tax slab. However, for LTCG, your returns of up to ₹1 lakh a year are exempt from taxes. Any gains beyond that attract a tax rate of 10% with no indexation benefits.  Also, irrespective of your holding period, your returns are also liable to a Health and education cess and surcharge at 4%.

Taxation on Dividend Income

Before the introduction of the Union Budget 2020, any dividend income in the hands of investors was tax-free as fund houses were required to pay Dividend Distribution Tax on it. However, at present any dividend income of investors is taxable under the head “Income from other sources.”

If your dividend income in a particular financial year exceeds ₹5,000, Asset Management Companies shall also deduct TDS of 10% before paying any dividend to you.

Takeaway

Even investing in the best equity mutual funds can become an unfavorable investment, if taxes are not taken into consideration. Learning about tax liabilities on equity mutual funds and planning them accordingly can help you bring down your taxes. Depending on that, you can also choose to invest in tax-saving funds if you find them suitable.