How are mutual fund returns taxed?

Understanding the tax implications of your mutual fund investments is crucial for both current mutual fund investors and those considering investing in the future. Mutual funds capital gains are taxed according to the holding period and fund type. Let us look at this in further detail.

What are capital gains?

When an investor sells their mutual funds at a higher price than what they had purchased them for, they make a profit. This profit that they make is termed as capital gain and is taxed in the hands of the investor depending upon the holding period and type of fund. Capital gains are further classified as short term and long term capital gains and can be defined as below:

Type of fund STCG LTCG
Equity mutual fundLess than 12 months12 months and longer
Hybrid- equity oriented mutual fundLess than 12 months12 months and longer
Debt mutual fundAlways short termAlways short term
Hybrid- debt oriented mutual fundAlways short termAlways short term

The tax on short term and long term capital gains are taxed at different rates:

Tax on equity mutual fund capital gains: If you redeem your equity fund units within one year, you'll incur short-term capital gains, which are subject to a fixed tax rate of 15%, regardless of your income tax bracket. Long-term capital gains are realized when you sell your equity fund units after holding them for over a year. These gains, up to Rs 1 lakh annually, are exempt from taxation. However, any long-term capital gains exceeding this threshold are subject to a 10% LTCG tax without the benefit of indexation.

Tax on debt mutual fund capital gains: Starting April 1st, 2023, debt funds will no longer enjoy the indexation benefit and the capital gains will always be treated as short-term. Consequently, gains from debt funds will be added to your taxable income and taxed according to the applicable slab rate.

Tax on hybrid mutual fund capital gains: The tax you pay on capital gains from hybrid or balanced funds depends on the equity/debt exposure of the mutual fund. If more than 65% exposure is in equity, it will be taxed like an equity fund. Otherwise, it will be taxed like a debt fund.

Here's a simplified summary of how capital gains on mutual funds are taxed:

Type of fund STCG LTCG
Equity mutual funds15%10% without indexation
Arbitrage funds15%10% without indexation
Aggressive hybrid funds15%10% without indexation
Other funds (atleast 65% in equity)15%10% without indexation
Debt mutual fundsSlab rateSlab rate
Floater fundsSlab rateSlab rate
Conservative hybrid fundSlab rateSlab rate
Other funds (35% or less in equity)Slab rateSlab rate
Balanced hybrid fundsSlab rate20% with indexation
Other funds (more than 35%, but less than 65% in equity)Slab rate20% with indexation

Tax on dividends offered by mutual funds: According to the revisions outlined in the Union Budget 2020, dividends provided by any mutual fund scheme are subject to taxation in the conventional method. This means that dividends received by investors are included in their taxable income and taxed based on their applicable income tax slab rates.

Tax on capital gains through SIPs: When you invest in mutual funds through a Systematic Investment Plan (SIP), the units are redeemed on a first-in-first-out (FIFO) basis. Let's consider a scenario where you invest in an equity fund via SIP for one year and decide to redeem your entire investment after 13 months.

In this situation, the units purchased first through the SIP are considered held for the long term (over one year), resulting in long-term capital gains upon redemption. If these gains amount to less than Rs 1 lakh, no tax is levied.

Conversely, short-term capital gains are realized on units purchased through SIPs from the second month onwards. These gains are subject to a flat tax rate of 15%, irrespective of your income tax slab.

Securities Transaction Tax: In addition to taxes on dividends and capital gains, there is a tax known as the Securities Transaction Tax (STT). The government (Ministry of Finance), imposes an STT of 0.001% when you opt to buy or sell mutual fund units of an equity fund or a hybrid equity-oriented fund. It's important to note that there is no STT applicable on the sale of debt fund units.