How Are Equity Mutual Funds Taxed?

The number of investors turning to equity mutual funds has been increasing constantly over the past few years. Many people see investing in mutual funds as a method to create long-term wealth. However, there is one element, apart from the Total Expense Ratio (TER) charged on your mutual fund investments, that also determines your eventual returns: taxes. Income tax on capital gains from mutual fund investments is higher on non-equity mutual funds and lower on equity mutual funds. This is true for both short-term and long-term capital gains. Understanding mutual funds taxation can help you maximize your returns to meet financial goals.

How Do Equity Mutual Funds Generate Returns?

If you understand equity mutual funds, you might know how they work. A mutual fund’s return on investment (ROI) highly depends on its underlying asset class and their performance. The primary source of return for equity mutual funds is an appreciation in the value of the shares of the companies in its portfolio.

Another type of return is when any of the underlying companies of these mutual funds declare bonus shares or dividends. Investors can get returns from mutual funds in two ways: capital appreciation and dividends. Note that you get dividends on mutual funds only in the income distribution cum capital withdrawal (previously known as dividend plans). Growth plans of mutual fund schemes don’t pay out dividends; the returns in growth plans are only through capital appreciation.

Factors Determining the Taxation of Mutual Funds in India

To understand taxation on mutual funds, you also need to understand the factors that determine tax liability. Essentially, there are three factors:

• Mutual Fund Type: From an income tax perspective, there are two types of mutual funds—equity-oriented and non-equity-oriented mutual funds. The category your mutual fund scheme falls under affects your tax liability.
• Capital Gains: When you sell a capital asset above its purchase price, you make a profit known as capital gains. It could be short-term or long-term depending on your holding period (the time you stay invested).
• Dividend: Dividend payout is the distribution of profits by a corporation to its shareholders. The Asset Management Company (AMC) of an equity mutual fund can choose to distribute such dividend income among the investors or reinvest it to generate higher returns.

How Are Equity Mutual Funds Taxed?

If you hold the units of your equity-oriented fund for 12 months or more, your capital gains will be classified as long-term. Gains from redeeming mutual fund units before twelve months from the date of purchase are classified as short-term capital gains.

Based on the duration of your holding, gains on equity mutual funds will be taxed as follows:

• If your holding period is less than 12 months, it is taxed as short-term capital gains at a flat rate of 15%.
• If your holding period is more than 12 months, your gains will be taxed as long-term capital gains at 10% without indexation benefits. There is an exemption of Rs 1 lakh on long-term capital gains from equity mutual fund units.

Taxation on Dividend Income

Before the introduction of the Union Budget 2020, any dividend income from mutual fund investments was exempt in the hands of investors. There was a dividend distribution tax (DDT) paid by fund houses on the dividend payout before remitting it to investors. After the DDT was repealed, any dividend income received by an investor is taxable under the head "Income from Other Sources" at the applicable tax slab rate.

If your dividend income in a particular financial year exceeds Rs 5,000, asset management companies shall also deduct TDS of 10% before paying any dividend to you.

FAQs

Q1. How are equity mutual funds different from debt mutual funds?

Ans. The fund manager of equity mutual funds primarily invests in equity-oriented instruments of different companies. On the other hand, debt mutual funds invest in fixed-income securities such as debentures, bonds, and money market instruments.

Q2. What are dividend mutual funds?

Ans. These funds invest 65% of their funds in companies that have the potential to distribute dividends to their shareholders regularly. These funds are also known as ‘dividend yield mutual funds.’

Q3. Is it better to hold my equity funds for the short or long term?

Ans. Ideally, holding equity mutual funds for the long term is better. Not only is the tax rate lower, but you can also claim an exemption on long-term capital gains under Rs 1 lakh. You can choose the holding period depending on your financial goals.