Usually, mutual fund investors make gains by way of capital appreciation and dividend receipts on the capital invested. In case of equity funds, the fund house declares dividends as and when the fund makes profits.
Similarly, the underlying assets in a debt fund provide regular interest at a fixed rate to the investors. This way, the value of your mutual fund keeps growing as you move ahead in your investment horizon. This brings capital gains to the investors which tend to be taxable.
Capital gains is the difference between the sell value of your investments and the initial purchase price.
In case of mutual funds, a differential rate of taxation is applied across fund categories. This tax rate depends on the type of mutual funds and the holding period. Holding period refers to the tenure for which an investor stays invested in a mutual fund scheme. Holding period can be short term and long term. In case of equity funds, a holding period of up to 1 year is regarded as short term and a holding period of more than 1 year is referred to as long term.
In case of debt funds, a holding period of up to 36 months (3 years) is referred to as short term and more than 36 months is regarded as long term.
How is capital gains taxed in mutual funds?
The capital gains earned in the short term are known as short-term capital gains (STCG). The capital gains earned in the long term are known as long-term capital gains (LTCG).
Equity funds and debt funds are taxed differently according to their holding periods. The short-term capital gains (STCG) on redemption of equity fund units is taxable at the rate of 15%. The long-term capital gains (LTCG) on equity fund up to Rs 1 lakh is tax-free. However, LTCG on equity fund redemption in excess of Rs 1 lakh is taxable at the rate of 10% without the benefit of indexation.
The short-term capital gains on redeeming units of debt funds forms part of the total income of the investor and is taxable according to his income slab. However, the long-term capital gains on debt fund redemption is taxable at the rate of 20% with the benefit of indexation. In case of indexation, you can adjust the cost of acquisition of the units according to the cost inflation index (CII) of the year of sale and year of purchase.
Indexed cost of acquisition (ICoA) is computed as follows:
ICoA = (Purchase Price * CII of year of sale)/(CII of year of purchase)
The main purpose of indexation is to inflate the cost of acquisition of the asset so as to reduce the resulting capital gains. This way, the investor is able to lower his overall tax liability.
How to manage tax on mutual funds?
The taxation on capital gains on mutual funds should not stop you from exploring its return potential. You can, actually, create a lot of wealth and fulfill your dreams via mutual fund investments. Instead of getting stressed, follow these simple tips to manage your tax on mutual funds:
- Before investing in any mutual fund scheme, make sure that you understand the product completely. In this way, you can stay invested in the product throughout the investment horizon without having to make unplanned exits which attract tax liability. Analysing the funds on qualitative and quantitative grounds helps to avoid selection of unsuitable funds. In case of any difficulty, consult a professional financial adviser.
- Refrain from frequent purchase and redemption of mutual fund units. If you are planning to initiate a systematic transfer from debt to equity fund or vice-versa, consider the tax implication. Each redemption is treated as withdrawal and is taxable as per the holding period. While investing in equity funds, have a long-term horizon of say more than 5 years to realise the full potential.
- Remember that in case of equity funds the maximum limit of exemption in LTCG is Rs 1 lakh per annum. You can think of positioning your portfolio investments in such a manner as to utilise this limit in the best possible manner.
- Your entire mutual fund investment should revolve around your financial goals. Those funds which are not functioning as per your goals can be redeemed promptly. Divert that money into funds which have been doing well consistently.
- Historically, equities have given above-average returns of around 12% over the long run. These have performed better than debt funds to give higher after-tax returns.