Did you know all about tax benefits of mutual funds in India

Benjamin Franklin once said that, the only two certainties in life are death and taxes. Death is unavoidable, but taxes can be reduced under certain circumstances, provided you understand the tax laws of the country well and make the right investment decisions. Unfortunately, many investors do not understand the tax consequences of their investment. The result is that, they either end up paying more taxes (getting lower returns) than expected or they do not disclose the correct taxable income in the Income Tax Returns (ITR).

Mutual funds are one of the most tax friendly investment options for investors in India. Tax benefits of mutual funds are much more compared to most traditional investment options in India, e.g. bank fixed deposits, Government small savings schemes etc. Most traditional investment options for retail investors in India are taxed as per the income tax slab rate of the investor.

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However, different types of mutual funds are taxed differently, depending on the nature of income / profits. Let us first discuss tax benefits of mutual funds from the profits arising from sale of mutual fund units – Capital gains.

Capital Gains: Capital gain is the appreciation in the value of the units of a mutual fund at the time of the sale. From a tax standpoint, there are two types of capital gains.

• Short term capital gain: If the units are sold within the period defined under tax laws, then it leads to short term capital gain. For equity funds (a fund in which at least 65% of the assets under management is allocated to equities or equity related securities is an equity fund) short term capital gain period is defined as, within 12 months from the date of investment for equity funds. For non-equity funds (a fund in which has less than 65% of the portfolio is allocated to equities or equity related securities is a non-equity fund) short term capital gain period is defined as, within 36 months from the date of investment.Short term capital gains (if the units are sold before one year) in equity funds are taxed at the rate of 15% plus Cess. Short term capital gains (if the units are sold before 3 years) in non-equity funds are taxed as per applicable tax rate of the investor. So if your taxable income is above Rs 10 lakhs then short term capital gains tax of your non-equity (debt) fund sale is 30% plus applicable Cess and surcharges.
• Long term capital gain: If equity fund units are sold after more than 12 months from the date of investment, then it leads to long term capital gains.If non equity fund units are sold after 36 months from the date of investment, then it leads to long term capital gains.This is one of the biggest tax benefits of mutual funds.Long term capital gains in equity funds are taxed at 10% provided the gain amount in a financial year is above Rs 1 Lakh. If the long term capital gain is less than Rs 1 Lakh then the capital gains tax is free.In case of non-equity funds, the long term capital gains are taxed at 20% with indexation. To calculate capital gains with indexation, you should index your purchasing cost by multiplying the purchasing cost with the ratio of the cost of inflation index of the year of sale and cost of inflation index of the year of purchase, and then subtract the indexed purchasing cost from sales value.

Dividends: Dividends are profits returned by a mutual fund scheme to the investor at regular intervals. However, the intervals are not certain and dividend amount is also not fixed. Mutual fund dividends received by investors are tax free in their hand. However, the dividend distribution tax (DDT) has to be paid by the AMC and thus has an impact on the final dividend received by the investor. Let us discuss dividend taxation for equity and non-equity funds.

You can check here – Historical dividends of mutual funds

• Equity Fund Dividends: While dividends are tax free for the investor, the AMC has to pay DDT at the rate of 10%.
• Non-Equity Fund Dividends: Non-equity fund dividends are also tax free for the investor; the AMC pays (DDT) before distributing dividends to investors at the rate of 29.12%.