There is a whole lot of jargon that surrounds investing in mutual funds. Potential investors grapple with complex names and types and struggle to differentiate one type of mutual fund from another. Having a clear understanding of these terms can help you take the first step towards investing comfortably.
As a basic rule, there are three main categories of mutual funds – equity, debt and hybrid or balanced. Mutual funds are broadly classified based on the investments made by the schemes or the asset allocation in their portfolio.
Equity mutual funds are those schemes that have invested more than 65 per cent of their assets in equity shares. At any point in time, at least 65 per cent of their investments are in equity. The remaining investments may be in debt instruments.
Taxation of equity mutual funds
You may have income from equity funds in two forms – dividends and capital gains.
Dividends are made tax-free in the hands of investors. But the fund house pays a dividend distribution tax (DDT) to the government before paying out dividends to the investors. Therefore, you are paid dividend net of DDT and it is not taxable in your hands.
Capital gains from sale of mutual funds are taxable in the hands of investors. The taxation of capital gains depends on how long you have held the mutual fund.
If an investor holds units of equity funds for less than one year, then his or her gains are termed as ‘short-term’. The short-term capital gains (STCG) are taxed at a flat rate of 15 per cent (an additional cess and a surcharge would be applicable). Investors make long-term capital gains (LTCG) if their holding period exceeds one year, and are taxed at the rate of 10 per cent if capital gains exceed Rs 1 lakh in the financial year.
Taxation of debt mutual funds
Mutual funds that invest more than 65 per cent of their assets in debt instruments such as treasury bills, government and corporate bonds are called debt mutual funds.
Like equity funds, dividends earned from debt funds too are not taxed in the hands of investors as the fund house pays a dividend distribution tax before paying out dividends.
The tax on capital gains depends on the holding period. Capital gains earned on sale of units within three years is termed ‘short-term’ and are taxed as per the income tax slab of investors.
However, capital gains made after a holding period of three years are termed ‘long-term,’ and are taxed at the rate of 20 per cent after allowing indexation of cost. Remember that indexation is mandatory and no choice is allowed.
Types of equity mutual funds
Equity funds are further classified based on the market capitalization and sector and theme. Irrespective of the further classification of equity mutual funds, all equity funds are taxed similarly, as mentioned above.
Large-cap funds: Large-cap equity funds allocate most of their assets towards equity shares of companies that are ranked 1-100 in market capitalization, in the list that will be periodically released by the Association of Mutual Funds in India (AMFI).
Mid-cap funds: Mid-cap equity funds invest mostly in equity shares of companies that are ranked between 101 and 250 in market capitalization.
Small-cap funds: Small-cap equity funds invest predominantly in equity shares of companies that are ranked 250 and below in market capitalization.
Multi-cap funds: Multi-cap equity funds invest in shares of companies across all market capitalization.
Sectoral funds: Sectoral equity funds invest in stocks of companies operating in a particular sector, for example, banking and pharmaceuticals.
Thematic funds: Thematic equity funds invest in equity shares of companies working around a common theme, for example, realty and travel.
Tax-saving funds: ELSS (equity-linked savings scheme) mutual funds are the only class of mutual funds that are covered under Section 80C of the Income Tax Act, 1961. ELSS investors can avail tax deductions of up to Rs 1,50,000 a year under this section.
Types of debt mutual funds
Income funds: These funds mostly invest in government-issued securities and money market instruments such as certificates of deposit.
Dynamic bond funds: These funds invest in debt instruments (predominantly in bonds) that have different maturities. The fund manager will change the asset allocation of the portfolio as per market movements.
Liquid funds: The main objective of these funds is to offer liquidity, and they invest in high-rated securities that mature within 91 days.
Credit opportunities funds: Credit opportunities funds invest in low-rated corporate bonds (AA or below) that are expected to deliver higher yields.
Gilt funds: These funds invest only in the securities that are issued by the Central and State Governments.
Fixed maturity plans: These funds are closed-ended and come with a fixed maturity period. One can invest in a fixed maturity plan only when it is available for subscription.
Short-term and ultra short-term funds: These funds invest in instruments having short maturities.
What are Hybrid Funds?
Hybrid funds invest across both debt and equity instruments to offer the benefit of portfolio diversification.
Equity-oriented hybrid funds: If a hybrid fund invests more than 65 per cent of its assets in equities, then it is considered as an equity fund for taxation.
Debt-oriented hybrid funds: If a hybrid fund allocates more than 65 per cent of its assets towards debt instruments, then it is considered as a debt fund for taxation.
Arbitrage funds: Arbitrage funds try to optimize returns by buying securities in one market and selling the same in another at a higher price. These funds are treated as equity funds for taxation.
Tax planning should be an integral part of an investor’s finances. Investors must be aware of how their investments are taxable on redemption.(The writer is founder and CEO, cleartax)