Taxation in Mutual Funds and Its Benefits to Investors

 Before Proceeding to on how tax process in Mutual funds, One must know how Mutual Funds work. 

Mutual Fund AMCs operate through Trustees and Sponsors and launch different category of MF schemes with permission and following Rules and Regulations assigned by SEBI (Securities Exchange Board of India) and SEC (Securities Exchange Commission) of Indian Government.

Mutual Fund schemes pools investors money and invest in portfolio of Stocks and Government Securities to adjust risk-free higher returns in exchange of little commission in the form of Expense Ratio which are charged on day-to-day basis.

I summarizing this through below Images.

Need of Mutual Funds:

How Mutual Funds Works?

Mutual Fund Operators:

Structure of Mutual Funds:

How Taxes are defined in Mutual Funds?

In the case of mutual funds, tax is always paid on the gains. Gain is the profit you have made.

Let’s say you had originally invested Rs 10,000 and a few years later, this grew to Rs 15,000.

So your gain is Rs 5,000. So the taxation will apply only on the Rs 5000.

If you make no profits from your investments or make losses, you do not have to pay any tax.

Another concept that investors need to understand is when the tax is paid.

You only pay a tax when you withdraw money.

If you invest today and withdraw 10 years later, you will pay a tax 10 years later on the gains.

Many salaried people tend to think they have to pay taxes on mutual funds every year. This is not true.

In the financial year, you withdraw your money, you have to file your returns even if you made losses.

You won’t have to pay any tax if you’ve suffered losses but will still have to show it while filing tax.

Categorization of Mutual Funds:

Mutual Funds Schemes comes into 3 Major Categories:

A) EQUITY (completely invest in Stocks); 

B) HYBRID (60 - 70% invest in Stocks and Rest in Govt. Securities)

C) DEBT (100% loan or invest in Corporate Bonds, TREPS, COD, Govt. Securities, etc.)

A) Equity MFs Tax:

As you might know, there are many kinds of equity mutual funds.

But, for taxation, all of them are treated equally. Whether it is a large cap fund or small cap fund, it’ll all be taxed similarly.

In case of equity mutual funds, different taxes are applicable for different durations.

If you invest in an equity mutual fund and withdraw in a year or less, your gains will be called short term capital gains.

Short terms gains are taxed at 15% of the gains.

So whatever your gains are, you will have to pay a tax of 15% of that.

For example: you invested Rs 1 lakh in an equity mutual fund in Jan 2018. By Oct 2018, this amount gad grown to Rs 1.1 lakh. You withdrew the entire amount.

So, since this is a period less than 1 year, you will have to pay a tax rate of 15%.

o, 15% of Rs 10,000 = Rs 1,500.

Now, if you sell after a period of 1 year from buying, your gains are called long term capital gains.

On long term capital gains, the tax rate applicable is 10% of gains.

But, there’s one more important detail.

You do not have to pay any tax as long as your long term capital gains from equity is less than Rs 1 lakh.

Example: you invested Rs 1 lakh in Jan 2019.

By Feb 2021, this had grown to Rs 1.3 lakh. So your gains are Rs 0.3 lakh or Rs 30,000.

Here, the gains are only Rs 30,000 - an amount less than Rs 1 lakh. So you do not have to pay any tax.

Now, in the same example, what if the amount invested was Rs 10 lakh and the final amount was Rs 13 lakh?

Then, your gains are Rs 3 lakh. This amount is higher than Rs 1 lakh, so you have to pay tax.

So, we take Rs 3 lakh, and remove the 1st 1 lakh (because you do not have to pay any tax for up to Rs 1 lakh gains).

So, we’re left with Rs 2 lakh. Of this, we need to find out 10%. That is Rs 20,000.

So in the second case, you have to pay a tax of Rs 20,000.

Mind you, this 1 lakh that is not counted in tax is not for one mutual fund. It includes all your equity investment gains for that financial year (all mutual funds and all shares sold).

C) Debt MF Tax:

There are many kinds of debt mutual funds.

The taxation for all of them works in the same way.

Just as it is with equity funds, in the case of debt mutual funds, different taxes are applicable for different durations.

But not everything is the same.

In the case of debt funds, if you withdraw from a debt mutual fund within 3 years of investing, the gain is considered short-term capital gain while greater than 3 years is considered a long-term capital gain.

In the case of short-term capital gains, the tax depends on the amount of money you earn.

The gains are simply added to your annual income and taxed as per the tax slab you fall in.

In the case of long-term capital gains, the tax rate is 20% of the gains irrespective of your annual income.

But, in the case of debt funds, you also get the benefit of indexation. This allows you to greatly reduce your tax burden.

What is indexation?

Over a period of time, your money is losing its value because of inflation.

So, for example, if you have made 8% in returns and the inflation is 4% per annum, your real returns are 4%.

What indexation does is calculates the gains based only on the real returns and not based on the full return.

Due to this, the tax you are supposed to pay is greatly reduced.

B) Hybrid MF Tax:

Hybrid or balanced funds that invest more in equity and less in debt are taxed like any other equity fund.

Similarly, hybrid or balanced funds that invest more in debt and less in equity are taxed like any other debt fund.

You can easily check what style a debt fund follows and you’ll know how the tax for them will be calculated.

For example, aggressive hybrid funds invest more in equities so they are taxed as any equity fund would. At the same time, conservative hybrid funds invest more in debt so they are taxed like a debt fund.

So, now you know how your equity, debt, and hybrid funds would be taxed.

These are simple to calculate if you invest once and withdraw once.

But what happens if you invest using an SIP? Then how is it taxed?

The answer to this is simpler than it sounds. Forget that you are doing an SIP. Think of each SIP as a single investment. Now calculate the tax for each installment.

This might seem a bit tedious but this is how it is done.

What about if you withdraw a partial amount only and not the full amount? How is the tax calculated then?

In that case, you will be taxed based only on the portion you have with drawn.

When you buy a mutual fund, you get a certain number of units. When you withdraw from a mutual fund, you are practically selling some of these units.

So, the NAV at the time you invested is taken as the initial NAV and the NAV at the time of withdrawing is taken as the final NAV.

Based on this, your gain can be calculated on whatever amount you withdraw.

And the tax is calculated on that gain.

Example:

You invested Rs 10,000 in a mutual fund. The NAV when you invested was Rs 100. So you got 100 units.

On a future date when you want to withdraw, the NAV is Rs 200.

You want to withdraw Rs 1000 and let the remaining amount stay invested.

So, you withdraw Rs 1000, which means, you have sold 5 units.

When you invested, the price of the units was Rs 100. And now they are Rs 200.

So your gain in 1 unit was = Rs (200 - 100) = Rs 100.

Since we withdrew 5 units, the total gain is Rs (100 X 5) = Rs 500.

Rs 500 is the gain you made.

Now, you can apply whatever mutual fund tax rules you have learned so far in this course to this Rs 500 gain based on the type of mutual fund it is.

This can be a bit complicated and intimidating. This is why we gave an example.

If you don’t understand, please do go through it again.

There are few other types of Mutual funds like ELSS, Fund of Funds, Index Funds, ETFs.

But what about the gains you make from the ELSS funds themselves?

They are also treated like gains from any other equity mutual fund you may have invested in.

s we’ve discussed, in the case of equity mutual fund gains, the first 1 lakh in gains made in any year are free from taxation.

When tax is calculated, the two numbers being compared are the NAV value you invested in and the NAV value you withdrew at.

So, if you want to reduce the tax you have to pay, you have to reduce the gap between the initial NAV and the final NAV.

Ideally, you want the gap to be high - it means you made good returns!

But you can increase your initial NAV value.

What many investors tend to do is, every financial year, they withdraw an amount which brings their gains to be less than Rs 1 lakh, and then, they invest it back in the same mutual fund.

Because the gains are less than Rs 1 lakh, you don’t have to pay any tax, and the NAV gets updated to a newer and higher value.

This method of reducing the tax burden is called tax harvesting.

It works for most investors up to a limit. Once your total invested amount grows beyond a certain point, it might make less sense.

Tax harvesting is possible only in the case of equity funds and not debt funds.