What are the Tax Benefits of Investing in Mutual Funds

Tax Benefits in Mutual Funds

Tax implications of mutual funds need to be understood to get a picture of post-tax returns. What is the nature of tax on mutual funds? At what stage and at what rate is the income tax on mutual funds imposed? Most of us understand tax free funds in the form of ELSS mutual funds or tax savings funds as they are better known. But that is just one aspect of the tax efficiency of mutual funds. There is a lot more to it.

You need to first understand what is income on mutual funds, because only income is taxed under the Income Tax Act. That comes in the form of dividends and capital gains. The capital gains tax on mutual funds is based on whether it is short term or long term. Similarly, ELSS tax benefit comes with a mandatory 3-year lock in of capital. Apart from equity funds, we shall also look at the tax on debt mutual funds as well as the idea behind tax saver mutual fund benefits in the investment app.

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What determines the taxation on mutual funds?

Taxation is based on 2 factors. Taxation on dividend on mutual funds is based on whether you opt for dividend plans or growth plans. In a growth plan, there is no dividend paid out and hence question of dividend tax does not arise. Dividend tax is only applicable in the case of dividend plans or capital distribution plans.

The other aspect on capital gains is based on the period of holding. In the case of equity funds, 1 year holding and above is long term gains and less than that is short term capital gains. However, in the case of non-equity funds, the funds have to be held for at least 3 years to be eligible to be classified as long term gains. Anything less than 3 years is short term capital gain in the case of non-equity funds.

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How are dividends on mutual funds taxed?

The idea of taxing dividends only apply to dividend plans and not to growth plans. The taxation of dividends has evolved in an interesting way over time. For instance, in the past, dividends were subject to withholding tax. It used to be 10% plus surcharge and cess for equity funds and 25% plus surcharge and cess for debt funds. This withholding tax was called dividend distribution tax.

Post the Union Budget 2020, government declared all dividends as taxable in the hands of the investor. It does not matter whether you earn dividends on equity funds or on non-equity funds, it will be treated as other income and taxed at your peak applicable tax rate. That rate could be 20% or 30% based on your tax bracket. However, there is a smart way to avoid this dividend tax. In case people need regular income, they can opt for a growth plan and structure pay-outs in the form of systematic withdrawal plan (SWP). That is more tax efficient. 

Taxation of short and long term capital gains on mutual funds

We know that the capital gains cut-off period is 3 years holding in the case of non-equity funds to be classified as long term gains, while in case of equity funds it is just 1 year. In case of non-equity funds, STCG is taxed at peak rate (20% or 30%), while in the case of equity funds, the STCG is taxed at a concessional 15%. In case of LTCG, tax levy is 20% on capital gains on non-equity funds with indexation benefits, while it is flat 10% in equity funds after a basic annual exemption of Rs1 lakh. In addition, long term capital losses can only be set off against long term gains. However, short term losses can be set off against STCG and against LTCG. That is an added tax benefit in mutual funds.

Finally, Equity linked savings schemes (ELSS) offer exemption under Section 80C of the Income Tax Act subject to a blanket ceiling of Rs1.50 lakhs. This entails a lock-in of 3 years. If you add up these various factors, then surely there is an element of tax efficiency in mutual fund investing.