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Mutual funds help in investing in a well-diversified portfolio of instruments like stocks, bonds, etc. Before investing in any asset, the first thing you need to know is whether you need to pay any taxes.
The short answer is Yes. In this article, we will break down the types of taxes you need to pay based on the type of funds and duration of holding.
Capital gains tax
The first and foremost tax you'll have to pay is the capital gains tax. Capital gains tax means, tax on the profit. That is, if you have made any profit by selling mutual fund units during a financial year, you may have to pay the tax. As long as you continue to hold the units, you do not need to pay capital gains tax.
There are 2 types of capital gains tax
- Long-term capital gains tax
- Short-term capital gains tax
As the name indicates, the categorization is made based on the holding duration of the mutual fund. However, the duration varies between equity and debt mutual funds.
| Type of fund | Long-term | Short term |
|---|---|---|
| Equity funds | more than 1 year | 1 year or less |
| Non-equity funds (invested on or after 1 April 2023) | taxed at slab | taxed at slab |
| Non-equity funds (invested before 1 April 2023) | more than 3 years | less than 3 years |
For debt and other non-equity mutual funds that invest not more than 35% in equity shares of Indian companies, investments made on or after 1 April 2023 are taxed at your income tax slab rate, irrespective of the holding period, without any indexation benefit.
Long-term capital gains tax
Long-term capital gains (LTCG) tax is applicable when you sell the mutual fund units after 1 year for equity-oriented mutual funds. A mutual fund is considered equity-oriented if at least 65% of the investible funds are deployed into equity or shares of domestic companies. For debt-oriented and other non-equity mutual funds, gains on investments made on or after 1 April 2023 are taxed at your income tax slab rate, irrespective of the holding period.
| Type of fund | LTCG |
|---|---|
| Equity funds | 12.5% on gains exceeding ₹1.25 lakh per year (if sold on or after 23 July 2024); 10% if sold before that date |
| Non-equity funds | Taxed at your income tax slab rate (for investments made on or after 1 April 2023) |
LTCG tax is applicable for equity funds only if the redeemed profit is more than ₹1.25 lakh in that financial year. That is, if your investment is 5 lakhs and becomes 10 lakh after 6 years, then your profits/gains would be 5 lakhs. If you decide to sell all the units on or after 23 July 2024, then you are liable to pay a tax of 12.5% on ₹3.75 lakhs (5 lakhs - 1.25 lakhs), which will be ₹46,875. The first ₹1.25 lakh of long-term gains is not taxable under LTCG for equity funds in a financial year. The ₹1.25 lakh exemption applies to your total long-term capital gains from equity-oriented mutual funds for the year, including gains from sales made before and after 23 July 2024. If you sell before 23 July 2024, long-term gains above ₹1 lakh are taxed at 10%.
Indexation
Indexation is something that helps in reducing the tax liability by adjusting the cost of acquisition to inflation. Say you have a CAGR of 12% over 10 years. 12% may not be your actual gain as money would have lost its value due to inflation during these 10 years. So, to adjust to inflation, indexation was used to calculate the true net gains on long-term investments.
Until FY 2023-24, you could use indexation benefit on non-equity-oriented mutual funds, property, gold, and other assets taxed under LTCG. The Union Budget 2024 removed indexation on all investments except real estate bought before 23 July 2024. Debt mutual funds purchased on or after 1 April 2023 are taxed at your income tax slab rate, without indexation, irrespective of how long you hold the units.
We can calculate the indexation using the following formula:
CII stands for Cost Inflation Index. To calculate indexed cost of acquisition, CII was launched with a value of 100 in the year 2001-02. You can view the value of CII for each financial year here.
The formula above is still relevant if you are evaluating tax on real estate bought before 23 July 2024, where you can choose between 20% LTCG with indexation or 12.5% LTCG without indexation.
Short term capital gains tax
Equity mutual funds sold within 1 year are subject to short term capital gains (STCG) tax as shown below. Gains on non-equity mutual funds purchased on or after 1 April 2023 are taxed at your income tax slab rate, irrespective of how long you hold the units.
| Type of fund | STCG |
|---|---|
| Equity funds | 20% (if sold on or after 23 July 2024); 15% (if sold before 23 July 2024) |
| Non-equity funds | Taxed at the investor's tax slab |
Tax on hybrid funds
If you are owning any hybrid/balanced funds, which have a combination of both debt and equity assets, then if the equity allocation is more than 65%, it is taxed as an equity fund, otherwise, it is taxed like a debt fund.
Cess and Surcharge
In addition to paying capital gains tax, you are liable for paying a 4% cess (health and education) on the income tax. That is, if the tax rate is 12.5%, it would become 13% and if it is 20% then it would become 20.8%.
In addition, you will have to pay a surcharge if your taxable income falls in the below brackets:
| Income slab | Rate |
|---|---|
| Income ₹50 lakh between ₹1 crore | 10% |
| Income > ₹1 crore | 15% |
Tax on dividends received
If you are invested in mutual funds which pay dividends at regular intervals (monthly, quarterly, etc) then the dividend is considered your income and you are liable to pay tax on the dividend as per your tax slab.
Prior to April 1, 2020, companies distributing the dividend used to pay dividend distribution tax, and hence dividends were not taxed at the hand of the investor.
Tax on ELSS funds
Equity Linked Savings Scheme (ELSS) helps in claiming tax deduction under 80C (up to 1.5 lakhs) on the invested amount. However, the gains are not tax-free. ELSS is considered equity funds and long-term capital gains tax applies to them at the same rates as other equity-oriented mutual funds. There does not arise a question of short term capital gains on ELSS funds as one can sell them only after 3 years.
Tax while investing through SIP
When you are investing through SIP, short term and long-term are considered based on the holding period of individual units.
Say, for example, let's say, you started SIP in a equity fund A on Aug 1, 2022, for ₹1,000 and the NAV of the fund is ₹100. You would receive 10 units of fund A, which will be subject to LTCG if you sell it after Aug 1, 2023. Units purchased in the next month (Sep 1, 2022) will be considered as long-term after Sep 1, 2023, and so on.
If you are withdrawing in multiple chunks, then the units purchased first will be sold first, in a First In First Out (FIFO) model.
Securities transaction tax
A Securities transaction tax (STT) of 0.001% is applicable when equity mutual funds are sold, on the sold value (capital+gains). This is paid by the AMC (mutual fund company) and the investor need not pay it separately.
Stamp duty
Starting July 1, 2020, a stamp duty of 0.005% is deducted from the investments you made, while purchasing the mutual fund units. This is why you will see that your SIP amount will show as ₹999.95 in your portfolio dashboard while you invest ₹1000.
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