Taxation And Mutual Funds: Understand How It Works

Mutual funds can be an ideal investment option for wealth creation. Whether it is about capital gains or earning a regular income, investors can choose from a wide variety of funds available in the market. Also, the capital gains from your investment are taxable as per the holding period and prevailing income tax laws. Let’s have an in-depth look at the various aspects of the taxation of mutual fund investments.

What Is A Holding Period In Mutual Funds?

Holding period refers to the time duration for which you remain invested in a given mutual fund. Your capital gains from mutual funds are taxed differently as per the holding period. In the case of equity funds, a holding period of less than one year is known as the short term. Conversely, a holding period of more than one year is known as the long term.

In the case of debt funds, a holding period of fewer than three years is known as the short term. On the other hand, a holding period of more than three years is known as the long term.

Thus, your capital gains will attract taxes based on your holding period. At this juncture, it becomes critical to know the exact meaning of capital gains and how these can be classified on the basis of a holding period.

What Are Capital Gains?

Capital gains relate to the difference between the price at which you buy the units of a mutual fund and the price at which you sell them. Take the example of an individual who invests Rs 2 Lakh in an equity fund on 1 January 2016. Assume that after 2 years, when they redeem the units, the value of the portfolio stands at Rs 2.5 lakh. Thus, they earn Rs 50000 by way of capital gains. From a holding period perspective, capital gains can be classified as Short-term Capital Gain (STCG) and Long-term Capital Gain (LTCG).

When you redeem the units of an equity fund within one year from the date of purchase, you tend to make capital gains known as STCG. On the other hand, if you redeem your investment after one year, then the underlying profit would be termed as LTCG.

In the case of debt funds, the classification is completely different. Your gains will be treated as STCG when you redeem your investment in debt funds within three years from the date of purchase of the units. On the contrary, if you redeem your investment after three years, then the underlying profit would be termed as LTCG.

How Do Tax Rates On Capital Gains Differ For Equity Funds And Debt Funds?

Ordinarily, short term gains attract a higher tax rate as compared to long term gains. In the case of equity funds, STCG is taxed at a rate of 15%. However, long term gains up to Rs 1 Lakh are tax-free and you are not required to pay any taxes on it. If your long term gains exceed Rs 1 Lakh, then these will attract taxes at the rate of 10% without indexation.

The rates of taxation for debt funds differ altogether. Short term gains are taxable at your individual income tax slab rates. However, long term capital gains attract a tax rate of 20% with the benefit of indexation.

In mutual funds, indexation is a way to adjust your capital gains as per the prevailing inflation index. This helps to lower your overall liability to pay taxes. The advantage of indexation is available only for long term gains made on debt funds.

How Can You Save Taxes Through ELSS Funds?

Amongst the various mutual fund categories, ELSS Funds offer you tax advantage along with the opportunity to create wealth. Investing in these funds makes you eligible to avail a deduction of up to Rs 1.5 lakh every year under Section 80C of the Income Tax Act. These funds have a lock-in period of three years after which you would be able to redeem your investments.