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What are the tax implications of nvesting in mutual funds?

Mutual funds have gained popularity among Indian investors as they offer a number of benefits like affordable professional management, diversification, liquidity, flexibility, etc. As with all other investments, mutual fund investing too has its own tax implications. Firstly, let’s understand how you earn from your mutual fund investments. There are two ways in which you can get your returns from your mutual fund investment. They are:

Dividends: The mutual fund scheme may declare dividends based on the investment gains generated by it. If you have opted for the ‘dividend payout’ option, you would receive these dividends as and when they are declared. You may also opt for the ‘dividend reinvestment’ option in which case, the dividend due to you is reinvested in the same scheme to buy more units. If you opt for the ‘growth’ option, no dividends are declared; instead, the profits are retained in the scheme.

Capital gains: In addition to dividends, the NAV (Net Asset Value) of the mutual fund scheme rises over time to reflect the rise in the market prices of securities that the scheme has invested in. When you redeem your mutual fund units, if the NAV has increased as a result of this rise in prices of securities, you will earn profits {Profit = Number of units x (NAV at which you redeem your units minus NAV at which you purchase your units)}. This is called capital gains.

Now that we have understood how we earn from investing in mutual funds, let’s take a look at the broad categories of mutual funds as per income tax.

Equity-oriented and debt-oriented schemes

All mutual fund schemes are broadly classified as equity oriented or debt oriented based on their portfolio characteristics. If the scheme invests at least 65 per cent of its corpus in shares and related instruments (like futures, options etc), it is classified as an equity oriented scheme. Otherwise it is treated as a debt oriented scheme. The two are taxed differently. But in general, equity oriented schemes suffer lower tax than debt oriented schemes.

Another aspect that we need to consider is the duration of investing in a mutual fund. This impacts the amount of tax we pay on the profits earned.

Short term capital gains and long term capital gains

Capital gains are taxed according to their holding period and the type of scheme. In equity oriented schemes, if you have held your investment for at least one year, it is treated as Long Term Capital Gain (LTCG). If the holding period is lesser than a year, it is treated as Short Term Capital Gain (STCG). For debt oriented schemes, the minimum holding period to qualify as LTCG is 3 years; if you hold for less than 3 years, the gains are treated as STCG. Generally, LTCG suffers lower taxation than the corresponding STCG.

Dividend Distribution Tax (DDT)

While all dividends are tax-free in the hands of the investor, debt oriented schemes deduct a certain potion of the declared dividend and pay it to the government as DDT. So the net dividend that you realize would be the gross declared dividend minus the DDT deducted. As the scheme deducts DDT and pays it, you have no hassles in this regard.

Now that we have understood how mutual funds are taxed, let’s take a look at the tax rates.

Tax rates for Financial Year (FY) 2018-19

Though mutual fund taxation is reasonably stable over time, there can be minor variations from time to time. Following is a compilation of the tax rates for the Financial Year 2018-19.

TABLE COMES HERE

^Indexation is the process of adjusting your original investment cost for inflation as you are expected to pay tax only on the gain that you make over and above inflation. Indexation is done based on "Cost Inflation Index" numbers released by the income tax department for each financial year.

In conclusion, mutual funds offer numerous benefits to investors and tax efficiency is one among them. Your net returns depend not only on the return generated by your investment but also on the taxation that it suffers. The tax that you pay on any gains from your mutual fund investments is relatively lower than on other comparable investment options and hence has the potential to boost your investment returns. This is one of the key reasons why mutual fund products are highly popular investment instruments.

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Key Takeaways

  1. Returns from mutual fund investments can take the form of dividend and capital gains.
  2. Capital gains may be long term or short term depending on your holding period.
  3. LTCG generally suffers lesser tax than corresponding STCG.
  4. Tax levied on mutual fund investments is relatively lower than on other comparable investment options.