Everything you (should) wanted to know about Taxation of your Mutual Funds


Posted By : Kushal Kothari

You have decided to start investing in mutual funds, and you are researching the best-rated funds at all the various sites. Kudos to you, but that’s just the part of the whole process. Tax planning is an integral step in your entire allocation strategy and can make a whole lot of difference to your returns.  Tax planning makes sure that money actually stays in your bank account, and is not paid as tax to the government (We are not saying paying taxes is bad, but let’s try not to pay more than what we owe to the government)
 
Let me start by introducing you to few basic terminologies –
Capital Gain Tax – Any returns from your investment, be it Fixed Deposits, Stocks, Mutual Funds etc., are all subject to tax laws. The returns you make from these investments are termed as capital gains. You are liable to pay your marginal tax rate (your highest tax bracket based on your total income) on these returns as well. This tax, for obvious reasons, is called the capital gain tax. However, in a bid to promote investors towards certain categories of investments, the government waives off the tax, or reduces it, given certain conditions. 
Which brings us to...
 
Tax on Equity Mutual Funds – Equity mutual funds do not attract any capital gain tax, provided you are invested in them for over a year as it is classified as Long Term Capital Gains Tax(LTCG). This is true for all equity oriented schemes. If you redeem the schemes before one year, they attract a Short Term Capital Gains Tax (STCG), which is currently at 15%, regardless of your income levels.


Tax on Debt Mutual Funds - Debt Mutual Funds are a bit tricky. If you redeem your scheme anytime before 3 years, it gets treated as STCG and you are taxed at your marginal tax rate. However, if you stay invested for over 3 years, it is treated as LTCG and you are taxed at 20% with indexation benefit.
 
--------------- Wait, but what is indexation benefit?---------------
Based on annual inflation, a rate of return number is fixed by the tax division for each year. Say this number is 5% for three consecutive years. So money at start of the period, say 100 Rs, becomes 100 *1.05*1.05*1.05 = 115.76
If your investment in Debt mutual fund gives a 10% return for three years, your investment at end of three years is 100*1.10*1.10*1.10 = 133.10
The LTCG you owe, should you choose to redeem your investment, is 20% of the difference between the above two numbers. i.e. (133.10-115.76) * 20% = Rs. 3.47 only + cess and surcharge
---------------------------------------------------------------------------------
 
Note that all the above taxes are to be paid in the year the scheme is redeemed. No tax is deducted at the source (TDS), which is the case for fixed deposits. Here’s a summary of Capital Gains on redemption

Capital Gain Tax table

 

Great info, but what can I really do with this information?

1. Investment in Debt funds is very efficient as compared to investing in FDs, and other bonds and deposits. Especially if you are in the 20% or 30% tax bracket. Get started now.


2. Investing in Equity Funds is more tax efficient as compared to Debt funds, for a period more than 1 year. If you are investing in a mix of Equity and Debt, you can consider Balanced funds instead. More on that in a post here


3. Arbitrage funds provide similar returns to liquid schemes but are tax-free after one year. Note, they are by no means a substitute for low-risk liquid funds. However, for those in the higher tax bracket, they definitely offer a better post-tax return.


4. DO NOT invest in Fund of Funds. Even if they invest in equities, they get taxed as Debt instruments, which is a double whammy, when you consider their higher expense ratio. 

 

Hope this helps planning your next Mutual Fund investment. Happy Investing!