Mutual funds are investment funds managed in a professional way. They are created by pooling in money from several investors to buy securities. These investors can be retail investors or institutional in nature. A portfolio of mutual funds includes stocks, equities, bonds, and other securities.
Mutual funds are the most cost-effective means of investment. They make it easy for consumers to start investing without the burden of selecting individual stocks. You can receive returns from mutual fund investments either through capital gains or dividends, depending on the type of fund you choose.
The tax on mutual funds also varies depending on the type of investment and the returns you receive. When starting your tax planning exercise for the year, factor in the applicable income tax on mutual funds as well.
(Read more: Taxes on inherited mutual funds)
There are different kinds of mutual funds. They can be broadly classified into the following types:
Money market funds are short-term risk-free debt instruments. For example, treasury bills come under this category. It is safe to invest in money market funds. This is because the chances of losing your principal amount are zero. Also, the returns on your investment are reasonable. On an average, these returns are higher than those you can expect from a savings account.
As the name suggests, income funds aim to provide a steady income to the investor. Suppose you invest some money in income funds. Your money will be re-invested primarily in high-dividend-generating government securities and corporate bonds. These assets will be held until maturity to ensure you earn regular interest.
Equity funds are also known as stock funds. These funds put in a major part of the invested amount in company stocks. There are different types of equity funds available in the market. They include large-cap, medium-cap, and small-cap funds, for instance. Suppose you wish to achieve long-term capital growth by investing in stocks. Then, you should opt to invest in equity funds.
Debt funds are also called credit funds or fixed income funds. They fall under the category of fixed income assets. These low-risk funds are used typically as strategic investments. So, they are ideal for investors who wish to limit their risks. Debt funds are invested in debt-oriented instruments. These include corporate bonds and fixed-income products. However, since debt funds carry low risk, their returns are also lower.
In balanced funds, the amount you invest is put into both debts and equities. Generally, 65% of the total amount is invested in equity funds and the remaining 35% in debt funds. Balanced funds lower the risks of investment. They also ensure higher returns. A combination of debt and equity funds in your investment portfolio will balance out expectations of risks and returns. So, balanced funds are a better investment option as compared to debt funds alone.
Mutual fund investments act as a source of income for investors. Different types of mutual funds offer different kinds of income. In some, income is generated in the form of capital gains. In others, it is in the form of dividends.
Where there is income, the question of paying income tax also comes into the picture. The tax you need to pay on your mutual fund investment depends on the type of fund you have invested in. The amount of tax will vary depending on the income earned, the holding period, and the type of mutual funds scheme.
You can invest in mutual funds for a short-term or a long-term period. For example, suppose you invest in a debt fund for less than three years. Then, your earnings from it will fall under the short-term capital gains (STCG) category. However, you may extend the duration of your investment beyond three years. Then, your earnings will be termed long-term capital gains (LTCG).
For tax purposes, money market funds are classified as debt funds or non-equity-oriented funds.
Tax levied on these funds falls under the following categories:
Long-term capital gains or LTCG (for funds held for three or more years):
Without indexation: 10%
With indexation: 20% (Indexation means adjusting the investment value from the date of investment till the date of redeeming the investment)
Short-term capital gains or STCG (for funds held for less than three years): These are taxed as per tax slab rates.
Dividends: Dividends earned from all kinds of mutual funds schemes are tax-free in the hands of the investor. However, the AMC has to pay dividend distribution tax of 15% as per Section 115O.
Equity-linked savings schemes (ELSS) are among the best tax-saving equity funds. The tax you need to pay on equity funds will depend on the duration of your investment as follows:
Long-term capital gains or LTCG (for funds held for more than a year): LTCG on equity funds is exempted from tax.
Short-term capital gains or STCG (for funds held for less than a year): The STCG tax rate on equity funds is 15%.
The general lock-in period for debts funds is three or more years. The tax rates for debts funds are as follows:
Long-term capital gains or LTCG (for funds held for three or more years): The LTCG tax rate for debt funds is 20%, which is calculated after indexation. This means that that value of the investment is adjusted from the date of investment to the date of redemption. Hence, indexation helps to reduce the investment value. This, in turn, reduces the tax liability.
Short-term capital gains or STCG (for funds held for less than three years): STCG is looked upon as a part of an investor’s income. Hence, they are taxed as per the prevalent tax slab rate.
In balanced funds, a major part of the investment is in equity funds. Hence, the tax liability is similar to that of equity funds.
Long-term capital gains or LTCG (for funds held for more than a year): LTCG on such balanced funds is exempted from tax.
Short-term capital gains or STCG (for funds held for less than a year): STGC on such funds has a flat tax rate of 15%.
There are various types of mutual funds offering different benefits. Some are high-risk investments while others carry low risk. Mutual funds help investors to diversify their portfolio and get optimum returns. The income tax you need to pay on earnings from mutual funds varies. It depends on the type of fund and the tenure of investment. To maximise returns, it is advisable to hold investments for a longer period of time.
Read more: Investment under other income
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