Tax on Mutual Fund: How Mutual Fund Returns Are Taxed?

Investing in mutual funds offers a flexible and potentially profitable way to grow your wealth. However, understanding the tax on mutual funds is crucial for effective financial planning. Taxation can significantly impact your returns, and knowing the latest rules helps investors maximise gains while staying compliant with tax laws. This article explores mutual fund taxation, the types of taxes applicable, and strategies to minimise your tax burden.

What is the Tax on Mutual Funds?

Many investors often ask, what is the tax on mutual funds? Simply put, mutual funds are subject to taxation based on the type of income generated - whether from capital gains or dividends. The Government of India taxes mutual fund returns under two heads:

• Capital Gains Tax: Tax on profits earned when you sell or redeem mutual fund units.
• Dividend Income Tax: Tax on dividends received from mutual fund investments.

Recent updates after the Union Budget passed in February 2025 have revised tax slabs and rebates, significantly influencing how mutual fund returns are taxed. These changes aim to simplify the tax structure and provide relief to small investors.

How are Mutual Fund Investments Taxed?

Mutual fund taxation depends on two primary factors:

1. Type of Mutual Fund: Equity-oriented or debt-oriented.

2. Holding Period: Short-term or long-term investments.

Capital Gains Taxation

• Equity-Oriented Funds:

  • Short-Term Capital Gains (STCG): If you have held an equity-oriented mutual fund for 12 months or less, gains made on selling the mutual fund units are taxed at 20%.

  • Long-Term Capital Gains (LTCG): If you have held an equity-oriented mutual fund for over 12 months, gains made on selling the mutual fund units are tax-free for gains upto ₹1.25 lakh. Gains exceeding this limit are taxed at 12.5%.

• Debt-Oriented Funds:

  • Regardless of the holding period, gains made on the sale of debt mutual funds are taxed as per the investor's applicable income tax slab rates.

Dividend Income Taxation

Dividends received from mutual funds are added to your total income and taxed according to your applicable income slab. A 10% TDS is applicable if the total dividend exceeds ₹5,000 in a financial year.

Types of Taxes on Mutual Funds

Understanding the different types of taxes helps in how to calculate tax on mutual fund redemption and mutual fund withdrawal tax:

1. Short-Term Capital Gains Tax (STCG):

   • Equity funds taxed at 20% if held for 12 months or less.

2. Long-Term Capital Gains Tax (LTCG):

   • Equity funds taxed at 12.5% beyond the ₹1.25 lakh exemption limit.

3. Dividend Distribution Tax (DDT):

   • Removed since 2020; dividends now taxed at the investor’s income slab.

4. Tax Deducted at Source (TDS):

   • A 10% TDS applies on dividend income exceeding ₹5,000.

   • Union Budget 2025 proposes increasing the TDS exemption limit on mutual fund income to ₹10,000.

Taxation of Different Mutual Funds

Different types of mutual funds have distinct tax treatments:

1. Equity Mutual Funds

• STCG: Taxed at 20% for holdings under 12 months.

• LTCG: Taxed at 12.5% after the ₹1.25 lakh exemption.

2. Debt Mutual Funds

• Gains are taxed according to your income slab, regardless of the holding period.

3. Hybrid Mutual Funds

• Taxation depends on equity exposure. Funds with over 65% equity are taxed like equity funds; otherwise, like debt funds.

4. Tax Exempt Mutual Funds

• While most mutual funds are taxable, tax-exempt mutual funds include investments like Equity Linked Saving Schemes (ELSS), which provide tax benefits under Section 80C if you opt for Old Tax Regime

Carrying forward of capital gain losses

We saw the taxation of capital gains on various mutual funds, but there may be times when you end up in losses on the redemption/sale of mutual fund units. In those cases, both - Short-term and long-term capital gain losses can be carried forward for 8 years and can be adjusted against respective capital gains in any of those years. You will have to file your Income Tax return promptly to enable you to carry forward losses.

How to Minimise Taxes on Mutual Funds?

Reducing your tax liability can boost your overall returns. Here’s how:

1. Opt for Long-Term Investments: Holding equity mutual funds for more than a year qualifies you for LTCG benefits of upto Rs 1.25L every year, reducing the tax burden.

2. Utilise ELSS for Tax Savings: ELSS tax benefits allow deductions of up to ₹1.5 lakh under Section 80C (applicable in the old regime).

3. Plan Mutual Fund Redemptions Wisely: Knowing how to calculate tax on mutual fund redemption helps optimise gains. Redeem funds in a manner that reduces STCG liabilities.

4. Choose Dividend Reinvestment Plans: Avoid TDS on dividends by opting for growth or reinvestment plans, though these come with LTCG implications.

Tax-saving Mutual Funds – ELSS

Tax saving mutual funds, such as Equity Linked Saving Schemes (ELSS), are popular among investors for their dual benefits:

• Tax Savings: Under Section 80C, investments up to ₹1.5 lakh qualify for tax deductions (only in the old regime).

• Short Lock-in Period: ELSS has the shortest lock-in period among tax-saving instruments - only 3 years.

• Growth Potential: As ELSS invests in equities, it has the potential for higher long-term returns.

• ELSS Tax Benefit: As ELSS have a mandatory lock-in of three years, gains made from them qualify as Long Term Capital Gains and are taxed at 12.5% after the ₹1.25 lakh exemption, aligning with equity fund taxation rules.

New Regime vs Old Regime: Impact on Mutual Fund Taxation

Understanding the difference between the new income tax regime and the old regime is crucial for mutual fund investors. Here’s how they compare:

Old Income Tax Regime:

• Allows multiple exemptions and deductions (e.g., Section 80C for ELSS investments).
• Suitable for investors who want to claim deductions for tax-saving instruments.
• Higher tax rates without deductions if exemptions aren’t utilised.

New Income Tax Regime (Post-February 2025 Updates):

• Lower tax rates with no exemptions for most deductions, including Section 80C.
• Tax rebate of ₹60,000 under Section 87A, making income up to ₹12 lakh tax-free.
• Ideal for investors preferring simplified tax calculations without exemptions.

Mutual Fund Taxation Impact:

• Under the old regime, ELSS investments still provide tax benefits under Section 80C.
• The new regime benefits investors with lower tax rates but without ELSS tax deductions.

Choosing between these regimes depends on your income level, investment strategy, and preference for claiming deductions.

Conclusion

Understanding tax on mutual funds is essential for optimising returns and ensuring tax efficiency. By knowing how to calculate tax on mutual fund redemption, leveraging tax-saving mutual funds, and utilising the ELSS tax benefit, investors can significantly reduce their tax burden. With the latest updates from the Union Budget 2025, including the ₹60,000 tax rebate, higher TDS exemption limits, and clear distinctions between the new and old regimes, mutual fund investments have become even more attractive for tax-conscious investors.