Introduction:
If you are thinking to start your investing journey, Mutual Funds can be the right option to invest. Mutual funds are a safer method of investment. Mutual funds are subject to a chain of the complex taxation system. Here you will get a clear-cut analysis and understanding of Mutual funds taxes. It is worth knowing that apart from primary taxes, Income Tax on Mutual funds for capital gain and redemption is also applicable for short- term capital gains. The amount of Capital gain tax depends on various factors like period of holding (short term or long term), type of funds invested in and your income tax slab. You may get confused with various kinds of investment options like Debt funds, ELSS funds, and Hybrid funds. You need not worry because here we will discuss them, Equity Mutual funds and Debt Mutual funds.
There are various kinds of Mutual funds but can be classified into two types; Equity Mutual funds and Debt Mutual funds. The rate of tax on Mutual funds capital gain varies. A person can invest either in Equity, Debt or both depending upon his market knowledge and experience. One of the hidden factors that we overlook is the tax that we have to pay. Let us understand the factors affecting Mutual funds taxation:
Key factors that determine the taxation on Mutual funds:
Tax on Mutual funds depends on various factors like the funds invested in the period of investment and many other ones. We will discuss each of them:
1. Investment duration
Your holding period determines your Mutual fund tax calculation. Your holding period can be short term or long term, for example, in the case of Equity Mutual funds, any holdings above one year are long term while below one year is being short term. In Debt Mutual funds, investment up to three years is short term while holdings beyond three years are long-term holdings.
2. Types of Mutual Funds invested in
We already know that Mutual funds are classified into Equity Mutual funds and Debt Mutual funds. Equity Mutual funds are riskier because they are subject to market volatility. They invest in Equity share and the stock market. Some popular Equity Mutual funds include small-cap, mid-cap, and large-cap funds. Liquid funds invest in short term financial schemes. They help you earn more returns than FD and savings accounts in a short period. Index schemes invest in SENSEX and NIFTY and your money grows with indices movement. Interval funds are funds that let you invest in both open- and close-ended funds. They give you the benefits of both kinds of funds.
Debt Mutual funds are a safer investment as they invest in corporate bonds, government bonds that offer fixed returns. Some of them are Liquid funds, short-duration funds and income funds.
3. Asset Turnover Ratio
The mutual funds turnover ratio is the frequency at which it buys and sells securities. Funds executing several trades throughout the year, having a high asset turnover ratio. To save tax, keep your Asset Turnover ratio low. The mutual fund capital gain calculator will calculate your asset turnover ratio to fetch accurate results. Long-term bonds and growth stocks are more tax efficient. Funds with high asset turnover have a higher expense ratio. These include administrative and security charges.
4.The Dividend Factor
If your chosen Mutual fund invests in dividend-paying stocks, then you receive multiple dividends a year. For some, it is like a source of regular income, but the tax bills can outweigh the profits. Dividends are like normal income, thus subject to taxation. Therefore, mutual funds that don’t pay a dividend are tax-efficient. Dividends earned are subject to tax every year while the capital gains are not. It means that equity investors earn more profit and grow exponentially faster than debt funds investors. A low dividend strategy works well for those who chase enormous fortune rather than regular income.
Taxation of Equity Mutual funds
There are two types of Equity investments, long term and short term. Funds held for over one year in Equity are called Long term capital gain (LTCG) while investments for tenure below one year are known as short-term capital gains (STCG). The short-term capital gains are subject to 15% tax 4% cess. IN LTCG, investments up to 1 lakh are tax-free and anything beyond this amount is subject to a tax of 10% +4% cess without indexation benefit. One of the most tax-efficient funds is Equity- Linked Savings scheme under Section 80c.
Taxation of Debt Mutual Funds
In Debt mutual funds, we consider investment tenure below 3 years to be short term while beyond 3 years as long term. According to the Mutual fund taxation, 2020-2021 norms, normal income tax is charged on short-term capital gains depending upon the investor’s income slot. For long-term capital gains, 20% +3% cess tax is charged with indexation benefit. Debt Mutual funds are tax-efficient as it offers indexation benefits. Indexation fund benefits are not available to Equity oriented mutual funds. People are often confused between debt funds and fixed deposits as both of them are low risk associated. The keynote here is- debt funds take into account market inflation. Therefore, the return on Debt Fund investment is higher than the fixed deposits. Investors who lie in higher tax slabs of 20% to 30% gain more from debt funds than those in the lower tax slab of 10%. The rate of Income-tax on mutual funds in India is directly proportional to the capital gains of the investor.
Conclusion:
Mutual funds investment is a great way to start your investing journey. You need not be an expert at it. Basic knowledge is enough to ace your game of investment. We all know that it is impossible to time the market, so it is wise to invest in high performing assets. One way to do this is the systematic investment plan (SIP). One should know the risk associated with mutual funds before investing. Sometimes the short-term gains can be disastrous. So be careful and invest through a trusted source.