Simplifying the Capital Gains Tax on Mutual Fund Investments

Before you choose to liquidate your mutual funds or even plan to invest in mutual funds, you should know how “capital gains” are taxed.  These are taxed as per the holding period, either as a short term capital gains tax or as long term capital gains tax.

What are capital gains?

Capital gains are the profit you make when you liquidate your mutual fund investments. For example, it’s the positive change in market value of the units of mutual funds at the time you sell it as compared to the value at the time you bought it.

If you have sold out your mutual fund units at a value higher than what you bought it for, then the profits are taxed as “capital gains”. At the same time, if the value of the asset has depreciated over time, then you would incur a “capital loss.”

For example, if an investment of Rs. 1, 00,000 is valued at Rs. 1,15,865 at the end of a period, then capital gains for the period would be Rs.15,865.

blog-capital gains infographic

There are also two types of capital gains: short-term capital gains and long-term capital gains.

                                                  Mutual Funds – Capital Gains Tax Rates
Types of MF schemeShort Term Capital Gains Tax Rate (STCG)Long Term Capital Gains Tax Rate (LTCG)
Equity Funds

 

15% (If held for upto a year)Nil (if held for more than a year)
Debt Funds

 

 As per Individual’s Income Tax Bracket (If held for upto 3 years) 20% with Indexation benefit (If held for more than 3 years)
  • Short term capital gains tax

If Debt Mutual Funds are held for a period lesser than 36 months or 3 years, then the returns are called as short term capital gains. Similarly, for equity funds the holding period of less than a year is considered as short term.

Short term capital gains of equity mutual funds are taxed at 15%, while that of debt mutual funds are taxed as per the income tax slab of the investor.

  • Long term capital gains tax

Long-term capital gain from equity funds are not taxed. However, for debt funds it is taxed at 20% with the indexation benefit.

With the indexation benefit, debt funds are a better choice to invest surplus money instead of the Fixed deposits, especially as bank interest rates are falling.

Let’s compare the same amount deposited for 3 years (2013-2016) in FDs Vs Debt Mutual Funds

         Fixed Deposits    Debt Mutual Funds
Amount Deposited/ Invested   Rs.10,00,000 Rs.10,00,000
Rate of Interest / Returns          7.5%     9.5%
Indexed Cost of AcquisitionRs. 10,00,000Rs.11,98,083
Tax Paid (for someone in highest tax slab)@30.9% = Rs.73,190@20% = Rs. 22,970
Returns Post TaxRs.11,63,671Rs.12,89,963
Net GainRs. 1,63,671Rs. 2,89,963
Additional Returns by investing in Debt Funds                                              Rs.1,26,292

(about 77% more than what you get from FDs)

Taxation of mutual fund dividends

Now, how about considering the taxation of dividend paying mutual funds?  For equity mutual funds, the dividend delivered is totally free of tax, not just for the investor but for the fund house as well. For debt funds, the dividend is tax-free for the investor, but the mutual fund company is liable to pay dividend distribution tax (DDT) at 28.84% prior to distributing the dividend to the investors. Since the DDT is paid from your investments, the NAV goes down after the dividend payout. To avoid paying unnecessary taxes, it is suggested that you opt for the growth option unless there is a need for regular income. By avoiding to pay taxes, your  investments, compound at a faster rate.

We can thus infer that staying invested for a long term is beneficial for the investor. In the case of equity funds, capital gains are free from tax, while for debt funds you can get indexation benefit if you stay invested for long.  For your financial planning and to know more about tax saving investments, you can approach our financial advisors.

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