In today’s world, almost everyone sees the value of investing in a mutual fund. Even though mutual funds have become so popular, not many people have a clear understanding of how they are taxed. While mutual funds have the potential to offer significant capital gains, a lack of awareness could lead you to make a costly mistake. If you’ve decided to invest in mutual funds, here’s everything you need to know about their taxation:

• What are the types of mutual funds?

Based on how assets are allocated, there are three broad categories of mutual funds,

1. Debt funds: Debt funds primarily invest in fixed-income securities; this includes instruments such as fixed maturity plans (FMP), liquid funds, short-term plans, long-term bonds, monthly income plans and so on.
2. Equity funds: Equity mutual funds make the majority of their investments in shares or stocks of companies. 
3. Balanced / Hybrid funds: These types of funds have an optimal mix of both investments in equity and debt instruments. The ratio between investments in the two categories may also change at different intervals or remain fixed. 

• How many ways can you earn from mutual fund investments?

In general, your earnings from mutual funds can either be in the form of dividends or capital gains. Dividends are the share of the profits you reap from your investments. Capital gains are the profits you make on either redemption or sale of your units. Capital gains can be further categories into short-term and long-term capital gains based on the holding periods. 

• Do the holding periods vary for different kinds of funds?

These are the classifications for holding periods of different kinds of mutual funds,

1. Debt funds: A holding period of less than 36 months is considered short-term, while 36 months or more is considered long-term.
2. Equity funds: A holding period of less than 12 months is considered short-term, while 12 months or more is considered long-term. 
3. Balanced / Hybrid funds: Here there are two different kinds of classifications based on whether a balanced fund is debt or equity oriented. Debt oriented funds have the same period as debt funds and equity oriented funds have the same period as equity funds.

• What are the taxes applicable on mutual funds?

Earlier tax on dividend called Dividend Distribution Tax (DDT) were paid by the fund house. Budget 2020 shifted the tax burden on dividends to retail investors. Dividend income from shares and MFs will be chargeable in the hands of the recipient at applicable income tax slabs.

1.   Debt funds: Long-Term Capital Gains (LTCG) on the sale of debt funds held for a period of 36 months or more is taxed at 20% post indexation. Apart from this you are also required to report any Short-Term Capital Gains (STCG), which is taxed in accordance to the income tax slab you fall under.
2. Equity funds: LTCG on equity funds is taxed at 10% if the capital gains you earn exceed INR 1 lakh in a financial year and there is no indexation benefit. Here an important point to note is that redemption for Equity Linked Savings Scheme (ELSS) funds can be claimed only after a minimum of three years, while other equity mutual funds do not have a lock-in period. Apart from this, STCG on the sale of equity mutual funds in less than a year is taxed at 15%. Hybrid funds with 65 per cent or more of their investments in equity and arbitrage funds are treated as equity funds for tax purposes.
3. Balanced / Hybrid funds: The taxation for balanced funds depend on the amount of equity they invest in. Similar to the classification of the period of capital gains, equity-oriented funds are taxed like any other equity fund while debt-oriented funds are taxed like any other debt fund.

The government also levies a Securities Transaction Tax (STT) of 0.001% on the sale of equity funds and balanced funds that are equity oriented. 

• Are there any other considerations?

If you choose to make investments through a Systematic Investment Plan (SIP) then it is important to remember that each periodical contribution is treated as a new investment. If SIP done in equity mutual funds, then each SIP has to complete one year to qualify for long term capital gains. Similarly, each SIP done in debt mutual funds has to complete three years to qualify for LTCG. Long term capital gains

Understanding the taxation on a product can assist you align tax planning in your overall financial planning. An advisor ensures that your investments are aligned to tax planning for the year in the overall scope of financial planning.