Tax on Mutual Funds - How to Calculate Mutual Fund Taxation?

Mutual funds are one of the most simple and convenient financial instruments for investors to participate in securities markets. Managed by professionals, mutual funds offer a gamut of choices, are flexible and investor friendly and also beneficial over other instruments from a tax perspective. It is pertinent for every investor to acquaint themselves with taxation before investing since taxes impact their cash flow.

In this article, we discuss tax implications of different types of mutual funds and changes in taxation after the recent Union Budget.

Mutual Fund Taxation

Taxes on mutual funds are dependent on various factors such as:

• Type of Mutual Fund: There are different categories of mutual funds depending on the asset class in which they are investing. Equity, debt, hybrid are broad categories of mutual funds and the taxation is not the same for each category.

• Holding Period: Gains from mutual funds are classified in short term and long term categories based on the tenure of investment. The tax rate differs according to the holding period.

• Individual’s Tax Bracket: Certain gains from mutual funds are added to an individual's overall income and taxed as per investor’s tax slab, hence tax can vary for different income groups.

• Capital Gains: Capital gains are profits made when selling NAV is higher than buying NAV. The tax is calculated on capital gains accrued on redemption of units.

• Dividends: Mutual funds distribute their profits via dividends when investors invest in dividend option of any mutual fund. This dividend income is taxed at source by AMCs.

Types of Mutual Funds and Their Tax Implications

Mutual funds investors accrue profits from their investments in two ways:

Dividends

Mutual funds distribute profits to investors by way of dividends. These dividends attract tax at the hands of investors and qualify as ‘Income from Other Sources’ for tax purposes. AMC also deduct a TDS if dividend exceeds Rs. 5000 which is adjusted in the investor's total tax liability. 

Capital Gains

Capital gain is simply the profit or additional money an investor makes from selling mutual fund holdings. Capital gains are subject to tax as per Income Tax rules. 

Capital Gains Tax on Mutual Funds (STCG, LTCG)

Capital gains tax on mutual fund returns is calculated on the basis of holding period. There are two types of capital gains: Short Term Capital Gain (STCG) and Long Term Capital Gain (LTCG)

They are defined according to the number of days the units are held.

Here’s a simplified table that explains holding period for different fund categories:

The table below covers the taxation on various categories of mutual funds:

*Applicable from 1st April 2025. Capital gains on units sold before 1 April 2025 will be taxed at slab rate.

+ Units bought prior to 1 April 2023 and sold after 2 years will be taxed at 12.5%

Capital Gains Tax on Equity Funds:

Equity or Equity-oriented funds (funds with > 65% equity exposure), when sold within one year of purchase, are liable to STCG of 20% as per new Union Budget announcement.

Units sold after one year attract 12.5% LTCG on capital gains over Rs. 1,25,000 in a particular financial year.

Capital Gains Tax on Debt/Debt Oriented Funds:

Prior to Budget 2024, debt & debt oriented funds (at least 65% corpus invested in Indian debt instruments) qualified for an LTCG of 20% with indexation benefits if they were sold after 3 years of holding. STCG was added to assessee’s income and taxed as per income tax slab rate.

As per revised rule, there is no LTCG on debt funds, all capital gains are subject to tax as per investor’s income tax slab rates.

For units bought before April 1, 2023 and sold on or after July 23, 2024, the LTCG is 12.5% for units redeemed after 2 years.

Capital Gains on Other Hybrid Funds:

Hybrid funds (>35% and < 65% in Indian equity) held for over 2 years are taxed at 12.5%. For holding periods less than 2 years, the gains are taxed as per income tax slab rates.

For example, international funds, Gold or Silver Funds, FOFs, and ETFs hold less than 65% in Indian Equity and are taxed as per above structure. 

How to Calculate Tax on Mutual Fund Redemption

Let’s take an example to understand Capital Gains Tax calculation.

Suppose an investor bought 10,000 units of an equity fund at NAV of Rs. 20.

Capital investment is 10000*20 = Rs. 200,000

After five years the NAV per unit is Rs. 35.

Assuming investor redeems all 10,000 units of holding @R.s 35 per unit:

Redemption amount is Rs. 35*10000 = Rs. 3,50,000

Investor’s Profit/Capital Gains = Rs 3,50,000 - Rs. 2,00,000 = Rs. 1,50,000

The capital gains tax is calculated on the capital gains i.e. Rs, 1,50,000.

If units were sold within one year of purchase:

STCG Tax = 20% of 1,50,000 = 30,000

How to Avoid Capital Gains Tax on Mutual Funds

While it is not possible to entirely avoid capital gains tax on mutual funds, you can find ways to minimise capital gains tax with simple strategies:

1. For equity funds, STCG tax is applicable when units are sold within a year of purchase. Therefore, it is advisable to hold equity fund units for one year and longer to avoid STCG of 15%.

2. LTCG on equity funds is applicable on capital gains amount above Rs. 1,25,000. It automatically saves tax on profits till this threshold.

For example, you invest Rs. 5,00,000 in an equity mutual fund on 1 August 2023 and sell units on 3 August 2024. Assuming the scheme delivered a return of 12% CAGR,

Capital Gain = Rs. 60,000

Tax on Capital Gain = NIL (No tax up to Rs. 1,25,000)

If you held these units till 3 August 2026:

Capital Gain = Rs. 2,02,464

Capital Gain that will be taxed = Rs. 2,02,464- 1,25,000 = Rs. 77,464

Capital Gains Tax on Rs. 77,464@12.5% = Rs. 9683

Thus, capital gains tax can be minimised by investing for long term.

3. Capital Losses: Long term capital losses booked in a financial year from underperforming assets can be offset against long term capital gains. Short term capital losses can be offset against both long term and short term capital gains. Refer income tax rules or your tax consultant for details.

Hence, investing for the long term in good quality assets is the best strategy to not only save on taxes but also even out short term volatility and generate good returns. Avoid frequent buying, selling of funds which may incur short term capital gains tax and eat into your returns.

Tax Benefits of Investing in Mutual Funds

There is a category of mutual funds known as ELSS (Equity Linked Saving Scheme) Fund, an excellent instrument to save tax and benefit from equity investing. Investment in ELSS up to Rs. 1,50,000 is eligible for tax benefit under section 80C of the Income Tax Act, 1961. 

ELSS funds have a lock in of 3 years that ensures funds are invested over a long term and benefit from compounding as well as market growth.

ELSS funds fare better over other tax efficient alternatives such as PPF, FDs, or ULIPs that have a much longer lock-in period. Moreover, they offer fixed & low to moderate returns with no upside potential.

ELSS funds offer dividend option for investors looking for income from mutual funds other than capital appreciation.

Investors can invest in ELSS through SIPs as well which means even small savings, regular monthly contributions can be channeled into tax efficient mutual funds.

Mutual Fund Tax Rates and Changes

In the Union Budget 2024, significant changes were introduced in mutual fund taxation, here’s a summary:

The tax on short term capital gains has been raised from 15% to 20%, and the tax on long-term capital gains has been increased from 10% to 12.5%.

The exemption limit for calculating capital gains has been increased from Rs. 1 lakh to Rs. 1.25 lakh.

The indexation benefit has been abolished in Union Budget 2024, made effective from July 23, 2024. Earlier, some investments enjoyed LTCG tax of 20% with indexation and 10% without indexation.

For calculating STCG and LTCG, now there are only two holding periods: 12 and 24 months.

There is common LTCG treatment for gold/silver ETFs and equity/hybrid Funds of Funds (FoFs). As per Budget 2024, the long-term capital gains on both domestic equity funds and foreign equity funds/ETFs/FOFs will be taxed at 12.5%. 

Conclusion

Mutual funds offer a host of benefits such as professional management, low cost, convenience and flexibility along with high return potential. Profits from mutual funds are subject to tax depending on the type of mutual fund scheme. After recent changes announced in the Budget, long term investing in mutual funds can help save taxes as well as generate wealth from market growth over a longer period.

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