Mutual Fund Taxation : How Mutual Fund Returns Are Taxed?

Mutual funds are popular in India. They offer flexibility, diversification, and possibly higher returns than traditional options, including savings accounts or fixed deposits. Like any investment, mutual fund returns are taxable, greatly affecting overall returns.

Understanding how mutual fund returns are taxed is important. It allows for better financial planning and sensible investments, especially considering changes in India’s Union Budget 2024.

The 2024 budget brought numerous notable revisions that tightened the rules for some mutual fund taxation areas and simplified others. These changes affect investors who rely on debt funds for steady returns. They force investors to review their plans and think about how taxes influence the net returns of their mutual fund investments.

This article will examine the taxation of mutual fund returns, including equity and debt funds, and explore the impact of recent tax reforms.

Taxation of Dividends from Mutual Funds

The Finance Act 2020, which fundamentally altered the handling of dividends for tax purposes, has significantly changed the taxation structure of mutual funds in recent years.

Pre-2020 Dividend Distribution Tax (DDT) Regime

The Dividend Distribution Tax (DDT) lets mutual fund investors enjoy tax-free distributions before April 2020. In this arrangement, mutual fund companies paid the dividend distribution tax (DDT) before giving dividends to investors, so investors didn’t have extra tax to pay.

The DDT rate ranged from 10% to 29%, depending on whether the fund was debt- or equity-based.

Still, this arrangement had several flaws. The corporate-level deduction of DDT resulted in higher taxes for certain investors, particularly those in lower tax bands, as their slab rates did not provide them with any benefits.

The mutual fund business carried the tax load, but investors finally paid for it via lower dividends.

Post-2020: Shift to Investor-Level Taxation

The Finance Act 2020 changed how dividends are taxed. Since April 2020, DDT has been removed, and investors now pay taxes on dividends themselves. This means dividend income from mutual funds is taxed the same as interest from deposits or rental income.

Dividends from mutual funds now count as part of the investor’s total income and are taxed according to their income tax slab. This implies that investors in higher tax ranges, such as the 30% bracket, will pay a 30% tax on their dividend income.

Lower-bracket investors—those in the 5% or 10% range—would pay less tax on the same dividend income.

Taxation of Capital Gains

The type of mutual fund (equity or debt) and your investment length determine how much capital gains tax is due. Based on their holding period, mutual funds are liable for Long-Term Capital Gains (LTCG) and Short-Term Capital Gains (STCG).

Equity Mutual Funds

Mutual funds classified as equity invest at least 65% of their corpus in Indian stocks. The following are the funds’ tax regulations:

• Short-Term Capital Gains (STCG): As short-term capital gains, profits from selling stock mutual fund units within a year of the 2024 budget revisions are taxed at a rate of twenty per cent. This regulation applies to all equity mutual funds, even those managed by Systematic Investment Plans (SIPs), which treat each instalment as a separate investment.
• Long-Term Capital Gains (LTCG): If you own equity mutual fund units for longer than a year, you may be eligible for Long-Term Capital Gains (LTCG). Relative to the 2024 budget, earnings over ₹1.25 lakh throughout a financial year are subject to a 12.5% LTCG tax. The longer-term investors have been drawn to the streamlined LTCG tax.

Debt Mutual Funds

Bonds and government securities are the main investments made by debt mutual funds. The tax treatment of these funds had a significant alteration in the 2024 budget:

• Short-Term Capital Gains (STCG): Your taxable income is increased by the short-term gains you realise from selling your debt mutual fund units for 24 months. Your income tax slab determines how these gains are taxed. This suggests that investors in higher tax bands may be liable to pay up to 30% in taxes on short-term capital gains from debt funds.
• Long-Term Capital Gains (LTCG): In April 2023, the indexation benefit for long-term capital gains (LTCG) on debt mutual funds was eliminated. In the past, long-term capital gains on debt funds were taxed at 20% with indexation, enabling investors to modify the purchase cost for inflation and lower their tax burden. Currently, no matter the holding period, capital gains from debt mutual funds are taxed at the investor’s income tax slab rate, which reduces their tax efficiency for long-term investors. This adjustment has brought the taxation of debt mutual funds in line with that of bank fixed deposits.

Hybrid Funds

Depending on their asset allocation, hybrid funds—which combine debt and equity—have different tax treatments. Debt-orientated hybrid funds follow debt fund tax rules, while equity-orientated hybrid funds (with over 65% in shares) follow equity mutual fund tax rules.

Investors trying to balance tax efficiency and risk in their portfolio will find this difference crucial.

Changes in the 2024 Budget: Simplified Taxation

The 2024 Union Budget made significant changes to mutual fund taxation, aiming to streamline the general framework:

• Reduced Holding Periods: The holding period to qualify for long-term capital gains tax on debt-orientated mutual funds has been reduced from 36 months to 24 months.
• Removal of Indexation for Debt Funds: Debt fund indexation is no longer applicable for units purchased after April 2023.
• Unified Tax Rates: Equity and non-equity mutual funds, including gold and overseas funds, now have a flat 12.5% tax rate on long-term capital gains if held for the required period.

With indexation removed, debt funds are now less tax-efficient, making it important for investors to review their portfolios and consider tax impacts when choosing mutual funds.

Impact on Financial Planning and Investment Strategy

Investors seeking to maximise their post-tax earnings must first understand mutual fund taxation. Taxes impact financial planning in the following ways:

Long-Term Equity Investors Benefit

Long-term investors still find equity mutual funds among the most tax-efficient investments available. They are ideal for long-term wealth accumulation and retirement planning, with a low LTCG rate of 12.5% and an annual exemption ceiling of ₹1.25 lakh.

Debt Funds: Less Tax-Efficient

The elimination of the indexation benefit on debt mutual funds results in less tax-efficient performance than in past times, especially for long-term investors. Investors in higher tax brackets may find debt mutual funds less appealing due to the taxation of short-term gains at their slab rate and the inability of indexing to reduce the 12.5% LTCG tax.

Balancing Risk and Tax Efficiency

Those seeking a balanced portfolio should consider their equity and debt exposure. While the tax treatment of hybrid funds depends on the equity-debt split, they offer a middle ground. 

While debt-heavy hybrid funds follow less favourable tax laws, equity-heavy hybrid funds are more tax-efficient.

Systematic Investment Plans (SIPs)

A mutual fund considers each SIP payment to be an individual investment. For tax purposes, we calculate each instalment’s holding term separately. Long-term capital gains only apply to SIP payments for either 12 months (for equity funds) or 24 months (for debt funds).

ELSS and Tax Savings

Under Section 80C, Equity-Linked Savings Schemes (ELSS) offer a tax-saving possibility with a deduction of up to ₹1.5 lakh. However, ELSS investments have a three-year lock-in term, and LTCG tax applies to any gains made beyond this time.

ELSS funds can be a wise option for those combining tax savings with equity exposure.

Security Transaction Tax (STT)

Securities Transaction Tax (STT) is a 0.001% additional expense when selling stock mutual fund units. In the meantime, STT does not apply to debt fund transactions.

Conclusion

The 2024 Union Budget significantly changed the taxation of mutual fund returns in India. Investors looking to optimise their portfolios for tax efficiency must first understand capital gains and dividend taxation. 

Long-term investors continue to benefit from the favourable tax treatment of equities mutual funds, but eliminating indexing benefits has reduced the tax efficiency of debt mutual funds.

Carefully analysing the tax impact of different mutual funds helps investors reduce taxes and increase post-tax gains. To make smarter investment choices, stay updated on tax rules and choose funds that fit your tax rate and financial goals.

The information contained in this article is intended solely for informational purposes and should not be interpreted as legal, tax, or financial advice. PowerUp is not liable for any errors, omissions, or outcomes that may arise from using this information, even though every effort has been made to ensure its accuracy.