How are Mutual Funds Taxed?

Mutual funds are regarded as a smart investing solution as they support achieving your financial objectives. One of the most significant advantages is that mutual funds are tax-efficient investment vehicles. But it is important to understand mutual fund taxation as it can help you plan your investments better.

Key Highlights

• The tax on mutual funds is the obligation to pay taxes relating to investment in mutual funds.

• Capital gains from selling units in a mutual fund are determined basis the holding period.

• As an investor, you should consider other factors besides taxation, such as tax on dividends, redemptions, etc., given the impact this may have on your cash flow.

Understanding Mutual Funds Taxation

If you are investing in mutual funds or plan to do so, you must know what tax will be paid on your profits. As with most asset classes you invest in, mutual fund profits and gains are subject to taxation. Understanding the rules of mutual fund taxation before you start investing will be helpful because tax is difficult to avoid.

You can plan your investments and learn about mutual fund taxation to reduce total tax costs. You can also take advantage of tax deductions for certain circumstances. Thus, be aware of the restrictions regarding mutual fund taxes while investing in them.

Factors Determining Taxation in Mutual Funds

Four significant factors determine taxation in mutual funds, as mentioned below.

1. Types of Funds
For tax purposes, the funds are classified into two groups: equity-oriented and debt-oriented.

2. Capital Gains
You will make a profit, known as capital gain if you sell an asset for more than it costs to buy.

3. Dividend
As an investor, you don’t need to sell your mutual fund units to receive a dividend. It’s simply a part of the scheme’s profits shared with you by the fund house.

4. Holding Period
The holding period is a determining factor for the tax to be paid on capital gains. If your holding period is longer, this will result in lower tax to be paid. The tax burden is reduced by keeping the investment longer because India's income tax laws encourage long periods to hold investments.

How do Mutual Funds Generate Profit?

Investment in mutual funds allows investors to profit from capital gains and dividends. A capital gain is the profit from selling an asset at a higher price than its cost. However, it is essential to remember that capital gains result from the redemption of mutual fund units. As a result, the capital gains tax on mutual funds will have to be paid at the time of redemption. Therefore, when the income tax returns for the current fiscal year are submitted, the tax on the redemption of mutual funds must be paid.

Dividends are another way mutual fund investors can receive income from a fund. The mutual fund declares dividends based on its accumulated distributable surplus. Dividends will be distributed at the discretion of the fund and are subject to taxation as soon as they are disbursed to investors. Consequently, investors must pay taxes when they receive dividends from their mutual funds.

Taxation of Dividend Provided by Mutual Funds

The TDS tax deducted at source also applies to the dividends of the mutual fund scheme. Since the laws changed, if an investor receives more than ₹5,000 in dividends within a financial year, the AMC is now obligated by Section 194K to withhold 10% TDS from the payout that the mutual fund delivers to its participants. Depending on your overall tax liability, you can claim 10% of the TDS deducted by the AMC when filing your return.

Securities Transaction Tax

Dividends and capital gains taxes are levied differently from the securities transaction tax. The government shall assess a STT of 0.001% when you buy or sell mutual fund units in an equity fund or a hybrid equity-oriented fund. However, the sale of debt fund units does not qualify for STT exemption.

Taxation of Capital Gain Provided by Equity Funds

Mutual funds with an equity exposure of at least 65% are classified as equity funds. As has already been mentioned, you will gain short-term capital gains when your equity fund units are redeemed within a holding period of one year. These gains are subject to an effective tax rate of 20%, regardless of your income tax bracket. You will realise capital gains on the sale of equity fund units after holding them for at least one year. Up to ₹1.25 lakh annually, these capital gains are exempt from taxation. A 12.5% LTCG tax is levied on any long-term capital gains exceeding this threshold, with no indexation benefit. 

Taxations of Capital Gains Provided by Hybrid Funds

Hybrid mutual funds are taxed basis their equity exposure. If a hybrid fund invests 65% or more of its portfolio in equities, it is treated as an equity-oriented fund for tax purposes. If the equity exposure is less than 65%, the fund is considered debt-oriented and follows debt fund taxation rules.

Taxations of Capital Gains Provided by Debt Funds

Debt mutual funds are subject to a different tax regime after the amendment introduced in the Finance Act 2023 For investments made on or after 1 April 2023, LTCGs and indexation benefits have been removed for most debt funds. Regardless of the holding period, all capital gains from such debt mutual funds are now treated as short-term and taxed as per the investor’s income tax slab. However, debt fund units purchased before 1 April 2023 and held for more than three years will continue to enjoy 20% LTCG tax with indexation.

How to File Taxes for Mutual Fund Gains?

1. Choose the appropriate ITR form

a. Use ITR‑2 if you have capital gains (including from mutual funds) and no business income. Use ITR‑3 if you have professional/business income along with capital gains.

b. For equity mutual funds with LTCG ≤ ₹1.25 lakh and no carry-forward losses, you may now use ITR‑1 or ITR‑4, subject to other eligibility criteria.

2. Gather documents

a. Download capital gains statements from RTAs (like CAMS, KFintech) or AMC statements. Cross‑verify with AIS/Form 26AS from the Income Tax portal to reconcile mismatches.

3. Report gains

a. Short‑term gains: enter in Schedule CG, using the consolidated STCG amount and cost details.

b. Long‑term gains: enter in Schedule 112A with scrip‑wise details or aggregated figures depending on acquisition date.

4. Claim loss set‑off

a. Short‑term losses can offset STCG/LTCG; long‑term losses can only offset LTCG. Filing before the due date (e.g. before Sept 15, 2025) enables carrying forward losses up to 8 assessment years.

5. File and e‑verify the ITR using the official portal before the deadline to avoid compliance issues.

Tax Saving Strategies for Equity Fund Investors

• Hold for at least 12 months to qualify for LTCG treatment: Gains above ₹1.25 lakh/year are taxed at 12.5%, while gains up to ₹1.25 lakh are exempt.
  

• Maximise the ₹1.25 lakh LTCG exemption: Plan redemptions such that you stay within the exemption and reinvest gains to compound.
  

• Use ELSS funds: Under Section 80C, you can invest up to ₹1.5 lakh in eligible ELSS schemes to claim deductions, while also earning long-term equity gains taxed at LTCG rates.
  

• Tax-loss harvesting: Strategically sell loss-making equity holdings before March 31 to offset STCG first and LTCG above exemption limit, reducing taxable gains.
  

• Use SIP investments: Spreads investments over time, leveraging compounding and possibly triggering long-term treatment for each tranche individually.
  

Conclusion

When investing in mutual funds, it is vital to consider the tax implications. As an investor, you should know the type of funds and the taxes levied on them to make effective tax planning. Mutual fund tax structures are designed to encourage investors like you to maintain mutual funds for an extended period for a taxed efficiency. This detailed guide will help you to easily understand how mutual fund taxation is done and how you can utilise this information to better plan your investments.

Also Read:

https://www.kotaksecurities.com/investing-guide/mutual-funds/mutual-funds-pre-requesites-and-tax-aspects/