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Mutual funds help in investing in a well-diversified portfolio of instruments like stocks, bonds, etc. Before investing in any asset, the first thing you need to know is whether you need to pay any taxes.
The short answer is Yes. In this article, we will break down the types of taxes you need to pay based on the type of funds and duration of holding.
Capital gains tax
The first and foremost tax you'll have to pay is the capital gains tax. Capital gains tax means, tax on the profit. That is, if you have made any profit by selling mutual fund units during a financial year, you may have to pay the tax. As long as you continue to hold the units, you need to pay capital gains tax.
There are 2 types of capital gains tax
- Long-term capital gains tax
- Short-term capital gains tax
As the name indicates, the categorization is made based on the holding duration of the mutual fund. However, the duration varies between equity and debt mutual funds.
| Type of fund | Long-term | Short term |
|---|---|---|
| Equity funds | more than 1 year | less than 1 year |
| Non-equity funds | more than 3 years | less than 3 years |
Long-term capital gains tax
Long-term capital gains (LTCG) tax is applicable when you sell the mutual fund units after 1 year for equity-oriented mutual funds and after 3 years for debt-oriented mutual funds.
| Type of fund | LTCG |
|---|---|
| Equity funds | 10% (when gains are more than 1 lakh) |
| Non-equity funds | 20% after indexation |
LTCG tax is applicable for equity funds only if the redeemed profit is more than 1 lakh in that financial year. That is, if your investment is 5 lakhs and becomes 10 lakh after 6 years, then your profits/gains would be 5 lakhs. If you decide to sell all the units, then you are liable to pay a tax of 10% on 4 lakhs (5 lakhs - 1 lakh), which will be ₹40,000. The first 1 lakh is not taxable under LTCG for equity funds.
Indexation
Indexation is something that helps in reducing the tax liability of the mutual fund. It helps in adjusting the cost of acquisition of mutual funds to inflation. Say you have a CAGR of 12% over 10 years. 12% may not be your actual gain as money would have lost its value due to inflation during these 10 years. So, to adjust to inflation, we have indexation benefit.
We can calculate the indexation using the following formula:
CII stands for Cost Inflation Index. To calculate indexed cost of acquisition, CII was launched with a value of 100 in the year 2001-02. You can view the value of CII for each financial year here.
Let's say you have invested ₹5,00,000 in a debt mutual fund in 2015-16. The CCI was 254. Assume that your investment grew to ₹7,00,000 in 2020-21 and you have decided to sell all units. In 2020-21 CII was 301. Now, you can calculate the indexed cost of acquisition as:
That is ₹5,92,519. So the indexed gains would be ₹7,00,000 - ₹5,92,519 = ₹1,07,481. So you'll have to pay 20% tax on ₹1,07,481, which is ₹21,496.
Short term capital gains tax
Equity mutual funds sold within 1 year and non-equity funds sold within 3 years are subject to short term capital gains (STCG) tax as shown below.
| Type of fund | STCG |
|---|---|
| Equity funds | 15% |
| Non-equity funds | Taxed at the investor's tax slab |
Tax on hybrid funds
If you are owning any hybrid/balanced funds, which have a combination of both debt and equity assets, then if the equity allocation is more than 65%, it is taxed as an equity fund, otherwise, it is taxed like a debt fund.
Cess and Surcharge
In addition to paying capital gains tax, you are liable for paying a 4% cess (health and education) on the income tax. That is, if the tax rate is 10%, it would become 10.4% and if it is 15% then it would become 15.6%.
In addition, you will have to pay a surcharge if your taxable income falls in the below brackets:
| Income slab | Rate |
|---|---|
| Income ₹50 lakh between ₹1 crore | 10% |
| Income > ₹1 crore | 15% |
Tax on dividends received
If you are invested in mutual funds which pay dividends at regular intervals (monthly, quarterly, etc) then the dividend is considered your income and you are liable to pay tax on the dividend as per your tax slab.
Prior to April 1, 2020, companies distributing the dividend used to pay dividend distribution tax, and hence dividends were not taxed at the hand of the investor.
Tax on ELSS funds
Equity Linked Savings Scheme (ELSS) helps in claiming tax deduction under 80C (up to 1.5 lakhs) on the invested amount. However, the gains are not tax-free. ELSS is considered equity funds and a 10% long-term capital gains tax applies to them. There does not arise a question of short term capital gains on ELSS funds as one can sell them only after 3 years.
Tax while investing through SIP
When you are investing through SIP, short term and long-term are considered based on the holding period of individual units.
Say, for example, let's say, you started SIP in a equity fund A on Aug 1, 2022, for ₹1,000 and the NAV of the fund is ₹100. You would receive 10 units of fund A, which will be subject to LTCG if you sell it after Aug 1, 2023. Units purchased in the next month (Sep 1, 2022) will be considered as long-term after Sep 1, 2023, and so on.
If you are withdrawing in multiple chunks, then the units purchased first will be sold first, in a First In First Out (FIFO) model.
Securities transaction tax
A Securities transaction tax (STT) of 0.001% is applicable when equity mutual funds are sold, on the sold value (capital+gains). This is paid by the AMC (mutual fund company) and the investor need not pay it separately.
Stamp duty
Starting July 1, 2020, a stamp duty of 0.005% is deducted from the investments you made, while purchasing the mutual fund units. This is why you will see that your SIP amount will show as ₹999.95 in your portfolio dashboard while you invest ₹1000.
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