Tax Implications of Investing in Mutual Funds
Watching children on a playground can sometimes give you tremendous insights into human nature.
One day, I observed a bunch of kids on the beach. They were using play buckets to collect wet sand, and transporting it further away to build sandcastles. One enterprising kid, Shyaam, decided that the small buckets were not doing the job.
He found a large discarded carton and decided he would work with that. But the base of the carton was rickety and unstable, and kept opening up. Despite his tiny hands making big efforts to keep the base from gaping open, he dropped shafts of sand on his way back from the water’s edge. He made as many - if not more - trips to the wet band of sand as the other kids, without realising that although he was collecting more sand in his large carton, he was spilling most of it on the way back, and therefore was ending up with very little wet sand after each trip.
In other words, he didn’t make much of a difference by going with a larger container.
This cute antic of the kid might be funny to the casual reader, but would you still be laughing when we tell you that a lot of us grown-ups apply a similar logic to our investments?
Taxation on our mutual fund returns – the equivalent of the gaping hole in Shyaam’s sandbox.
Taxation of Mutual Funds
The hole in your mutual fund sandbox appears when you redeem your investment and/or earn from it - that’s when the taxes kick in. Do you know how much of your returns is eaten by taxes?
Tax on mutual funds is influenced by various factors such as the kind of funds you have chosen to invest in, the duration of your investment, the income tax slab you belong to, etc.
Taxation of Equity Mutual Funds
There are two ways to earn from mutual funds - Capital Gains and Dividends. Both are taxed.
1. Capital Gains Tax
The profit you make when you sell the units of your mutual fund investments is called capital gain. Capital gains are taxable.
The Capital Gains Tax is dependent on the holding period of the mutual fund investment. Holding period refers to the length of time you are in ownership of the mutual fund units. If you hold an equity mutual fund investment for more than one year, you are liable to pay Long Term Capital Gains tax, and if you sell within one year, you have to pay Short Term Capital Gains Tax.
a. Long Term Capital Gains Tax (LTCG):
Long term capital gains tax applies to profits made from sale or redemption of equity mutual fund investments held for more than one year. The rate of tax is a flat 10%. However, this tax is exempt in cases where your profit is less than Rs 1 lakh in the financial year.
Note that the tax liability arises only when you sell your investments at a profit. There will be no tax for unrealized capital gains.
For example, let’s say Mr. Sharma has been holding units of a top-performing mutual fund for the last few years. His initial investment in this particular fund was Rs 50,000, and now the current value has gone to Rs 1,60,000. If he chooses to redeem his investment, he will be liable to pay 10% long-term capital gains tax on the profit he earns.
Mr. Sharma’s capital gains = (Selling price Rs 1,60,000 - Buying price Rs 50,000) = Rs 1,10,000
Tax = 10% of Rs 1,10,000 = Rs 11,000
Mr. Sharma will have to shell out Rs 11,000 in taxes.
b. Short-term Capital Gains Tax:
Let’s assume Mr. Sharma sold units of another equity mutual fund within six months of investment. And he booked a profit of Rs 50,000 on it. This amount would be treated as his short-term capital gains and would be taxed at a rate of 15%.
Short Term Capital Gains Tax is a special rate of tax applicable on the money you make from the sale of equity fund units which you have held for less than one year. This 15% tax is applicable on your profits, irrespective of which income tax slab you belong to.
Therefore, Mr.Sharma would effectively have to shell out approximately Rs 7,500 (plus cess/surcharges) in taxes on the Rs 50,000 that he earned on his mutual funds.
Note that short-term capital gains below Rs 1 lakh too are taxable (unlike the case of its long-term counterpart where capital gains only above Rs 1 lakh are taxable).
2. Tax on Dividends
Dividend payouts from mutual funds depend on the type of mutual fund scheme you have chosen - a growth mutual fund or a dividend fund.
In the growth option, there is no interim payment of dividends. However, in case you choose the dividend option, you will receive dividend payouts. This amount you earn is added to your regular income and taxed as per the income tax slab applicable to you.
This is one of the main reasons why a growth option makes more sense to invest in if you belong to the higher tax brackets. They give better post-tax returns than the dividend option of mutual funds.
3. Securities Transaction Tax (STT)
Beyond capital gains taxes, when you buy or sell stocks or mutual fund units on a recognized stock exchange, a tax called securities transaction tax or STT applies. It is 0.001% in case of mutual funds and 0.1% in case of delivery transactions.
Taxation of Debt Mutual Funds
The holding period that determines the long-term and short-term gains are set at the three-year threshold for debt funds (unlike the one-year in equity mutual funds).
When you sell a debt mutual fund within 36 months - 3 years - the short-term capital gains tax is calculated by adding the profit to your income as is taxed according to your income tax slab (Just like dividends are taxed in equity mutual funds!).
If you redeem debt funds after three years, a long-term capital gains tax is applicable at 20% with indexation benefits. Indexation takes into account inflation over the period of investment and adjusts the purchase cost. What this does is that it brings down the total earnings you make (on paper, for taxation purposes only) and saves tax outgo.
Let’s illustrate this with our example of Mr. Sharma. Let’s assume Mr. Sharma invested Rs 1 lakh in 2014 in a debt fund. He decided to redeem it 4 years later, once his investment had become Rs 1,80,000. His capital gain is Rs 80,000.
Without indexation, this Rs 80,000 will be taxed as per the income tax bracket applicable to Mr. Sharma. If he is in the 20% or 30% tax bracket, his profit for this debt fund will be taxed Rs 16,000 or Rs 24,000, respectively.
However, if Mr. Sharma chooses to make use of the indexation benefit that debt funds enjoy, the tax will be calculated at a flat 20% with adjustments made for inflation.
In 2014, the year of investment in the debt fund, the CII was 240. In 2018, when Mr. Sharma redeemed his holding, the value increased to 280 (CII is the cost inflation index declared by the Central Board of Direct Taxes).
Therefore, his indexed investment cost or purchase price = original investment amount x (CII of the sale year/CII of the purchasing year)
= 1,00,000 x (280/240) = Rs 1,16,666.67
Now, because the purchase cost has increased on paper, Mr. Sharma’s profit will be affected too.
Capital gains realised = Redemption Value - Indexed Purchase price
=Rs 1,80,000 - 1,16,666.667 = Rs 63,333.33
Now, the 20% tax is applicable on Rs 63,333.33, and not on the Rs 80,000 he actually made!
Total tax from this investment = Rs 12,666.66! This is the benefit of indexation, available only to debt funds.
Taxation of other Mutual Funds
ELSS: For savvy investors who seek tax saving along with equity exposure, mutual funds offer tax-saving schemes called Equity-Linked Saving Schemes (ELSS). They are essentially equity mutual funds (with tax benefit), and are treated similarly for taxation purposes. The tax benefit is that contributions upto Rs 1.5 lakh are eligible for tax deduction under Section 80C of the Income Tax Act. ELSS are known to give the best post-tax returns when compared with other tax-saving investments.
Balanced or hybrid funds: These funds invest in two or more asset classes - typically equity and debt. Hybrid funds with more than 65% allocation to domestic equity in their portfolio are taxed similar to Equity funds, and those with less than 65% equity allocation are taxed like debt funds.
Gold Mutual Funds: Investments in gold through mutual funds or Exchange Traded Funds (ETFs) are taxed similar to debt funds. The time threshold for gold investments is 3 years. Short-term capital gains are added to income and taxed as per the income slab. LTCG tax of 20% is applicable with indexation benefit.
International Mutual funds and Fund of Funds: Earnings from foreign funds are also taxed similar to debt funds. Gains made within 3 years are treated as short-term gains. They are added to income and taxed as per the income tax slab applicable. Long-term gains - profits made after 3 years of investment - are taxed at 20% with indexation benefit.
SIP Investment taxation: In the case of SIP (systematic investment plans), each periodic purchase is considered as a new investment. That is, after 13 months of starting a SIP, only the first investment will be taxed for long-term capital gains while all others will be considered for short-term capital gain.
In essence, most mutual funds are taxed on the basis of the inherent feature of them having either the equity-bent or being more debt-oriented. So, like Shyaam, would you have brought back the same amount of sand (in your case, earnings) if you had forgone the problematic carton (in your case, the more heavily taxed investment option)?
Equity-linked mutual funds are interesting options that investors may explore because of their tax saving feature along with exposure to equities for potentially higher returns.
Something I forgot to mention about Shyaam was that his hands and clothes ended up a lot dirtier than the other kids because of his dripping sandbox. In the same way, aside from taxation, there are other factors to consider when choosing an investment route. Add that to your rule book - always look at the big picture when choosing your investments.
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