In mutual funds, the tax is applicable on capital gains earned during redemption and on the dividends. This tax on mutual funds is categorised under the head of ‘Income from capital gains’ in the income tax. Planning investment redemption is facilitated by these norms. They differ based on the mutual fund category. Moreover, investors opting for a dividend option  receive their dividends after charging tax deducted at source (TDS). Understanding the types, rates and norms of mutual fund taxation is crucial for investors.

Mutual Funds Taxation

The tax liability in mutual fund investments can arise mainly in two ways as follows:

  • Income tax on mutual funds through capital gains.
  • Tax Deducted at Source (TDS) through dividend income.

Moreover, investors pay Security Transaction Tax (STT) on the equity-oriented funds. However, its charge is considerably low.

Source: Association of Mutual Funds in India

Apart from this, the Equity-Linked Savings Scheme (ELSS) is an exception to these norms. It allows one to claim a deduction of income from these funds while paying income tax. It can be obtained under Section 80C.

Understanding the mechanism and rates of mutual fund tax is crucial for investors to manage their transactions, plan their redemption and minimise the tax burden.

Tax on Dividend

Investors will receive dividends from the fund house under the ‘Income Distribution cum Capital Withdrawal’ or IDCW option. This dividend is distributed by the fund houses from their own profits. It reduces the Net Asset Value (NAV) compared to the Growth option, where this profit is reinvested in the scheme. 

However, the fund house charges Tax Deducted at Source (TDS) on this dividend income. When dividend income for an investor exceeds ₹5000:

  • 10% TDS is charged for all categories of mutual funds.
  • 20% TDS is charged if an investor has not furnished the Permanent Account Number (PAN) card details.

Note: These rates are applicable to resident individuals and domestic companies.

Tax on Capital Gains 

When investors sell their mutual fund units, it is known as redemption. The gain from these redemptions is considered under the capital gains head. Based on the tenure of holding the investments, this gain can be categorised into two types – Short-Term and Long-Term. Moreover, the taxation will differ based on the mutual fund category. These categories are:

  1. Equity-Oriented Funds: Investing majorly (minimum 65%) in equity shares.
  2. Specified Mutual Funds: They invest 65% or more in debt and money market assets.
  3. Other funds: Funds not classified in the above categories.

Short-Term Capital Gains Taxes

When an investment is held for a period less than the holding period, it is known as a short-term investment. Regulators usually discourage short-term investments as they cause volatility in the market. Therefore, the income tax on mutual funds held for a short period is higher than that held for longer. However, this holding duration would differ based on the category of investment instrument. 

CategoryHolding period  for Listed assetsHolding period for Unlisted assetsRate
Equity-Oriented Funds12 months12 months20%
Specified Mutual Funds––At the investor’s income tax slab rate
Other Funds12 months24 monthsAt the investor’s income tax slab rate

Note: These rates are for gains earned after July 23, 2024. Gains earned before this date would be taxed as per old norms.

Long-Term Capital Gains Taxes

When an investment is held for a minimum of the holding period or more, it is considered to be a long-term investment. Income tax on mutual funds held for a long-term will be lower and as follows:

CategoryHolding period  for Listed assetsHolding period for Unlisted assetsRate
Equity-Oriented Funds12 months12 months12.5%(Exemption up to ₹1.25 lakhs gains)
Specified Mutual Funds––At the investor’s income tax slab rate
Other Funds12 months24 months12.5%

Note: These rates are for gains earned after July 23, 2024. Gains earned before this date would be taxed as per old norms.

Hypothetical Example for Calculation of Tax on Mutual Funds

Understanding the taxation with this hypothetical example can simplify the structure.

Ms K invested ₹3 lakhs in multi-cap funds on January 20, 2024. Due to a significant rise in the NAV, she found the opportunity to sell this investment on September 3, 2024. She received ₹5.5 lakhs in this transaction. However, she held these mutual fund units for less than 12 months. 

ParticularsDetails
Investment fundMulti-cap fund (categorised as equity-oriented fund)
Investment amount₹3 lakhs
Redemption amount₹5.5 lakhs
Holding Period7 months, 14 days (January 20, 2024 to September 3, 2024)
Short-Term Capital Gains₹2.5 lakhs
Tax on STCG2.5 lakhs*20% = ₹50,000

However, if she sold these investments on or after January 20, 2025, at ₹6.25 lakhs, then her capital gains would be charged as per long-term investment norms as follows:

ParticularsDetails
Investment fundMulti-cap fund (categorised as equity-oriented fund)
Investment amount₹3 lakhs
Redemption amount₹6.25 lakhs
Holding Period12 months (January 20, 2024 to January 20, 2025)
Exemption₹1.25 lakhs
Long-Term Capital Gains3.25 lakhs – 1.25 lakhs = ₹2 lakhs
Tax on LTCG2 lakhs*12.5% = ₹25,000

As observed, the tax liability in the long term is lower than in the short term. Similarly, investors can calculate their potential tax liability with expected returns to make informed decisions for mutual funds.

Conclusion

Investors pay tax on mutual funds mainly through their capital gains and dividend incomes. The rates, tenure and liability for this may differ based on the fund category. Dividends are taxed by fund houses through TDS. Capital gains are paid by the investors directly under a separate head in income tax. Decoding this taxation structure can help investors manage their investments with efficiency.

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