Mutual funds are the most popular investment vehicles today. As you can invest in different asset classes through mutual fund schemes, there is a fund for every type of investor. Mutual funds are easily accessible through online platforms, financial product distributors, and mutual fund distributor services. However, it is important to understand how a mutual fund works and what are the complexities involved to make an effective investment decision.
Mutual funds are broadly categorized into three types based on the asset classes they invest in – equity mutual funds, debt mutual funds, and hybrid mutual funds. When it comes to income tax perspective, hybrid funds are taxed as either debt-oriented funds or as equity-oriented funds depending on the percentage of allocation into the asset classes. Each mutual fund scheme that you invest in can generate two types of income –dividends and capital gains at the time of sale.
What is dividend income?
Dividend income is paid by schemes that invest in stocks of dividend-paying companies (that distribute the profit in the form of dividends). Dividends received were tax-free in the hands of the investor prior to 31st March 2020. However, with the amendments in The Finance Act, 2020 there is a TDS (tax deducted at source) of 10% applicable on the dividend income that exceeds INR 5,000.
What is capital gain? How it is calculated?
Capital gain is the profit generated from the sale of mutual funds. The method of calculation of capital gains is the same for all mutual fund schemes i.e., for both equity and debt mutual funds. However, the tax implication is different. Let’s understand more about capital gains.
Capital gains are categorized as two types based on the holding period of the investment- short-term capital gains and long-term capital gains.
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Short-term capital gains: In an equity mutual fund, capital gains generated by an investment that is held for less than 12 months are referred to as short-term capital gains. In the case of debt mutual funds, short-term capital gains are gains generated by investments held for less than 36 months.
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Long-term capital gains: In an equity mutual fund capital gains generated by an investment that is held for more than 12 months are referred to as long-term capital gains. In the case of debt mutual funds, long-term capital gains are gains generated by investments held for more than 36 months.
Capital gains on mutual funds can be calculated as below:
Capital gains = Fund value at the time of sale total cost of sale – total cost of acquisition of the fund
How capital gains are taxed?
Tax implications are different for capital gains from equity mutual funds and debt mutual funds. Let’s take a look at the tax treatment of capital gains of equity and mutual funds
|
Capital gain type |
Equity Mutual Funds |
Debt Mutual Funds |
|
Short-term capital gains |
Taxed at 15% + cess + surcharge |
Taxed as per individual investor’s income tax slab rate |
|
Long-term capital gains |
Gains above INR 1 lakh a year are taxed at 10% without indexation benefit + cess + surcharge. Tax exemption is provided if the gain is within INR 1 lakh a year. |
Taxed at 20% post indexation + cess + surcharge |
The amount of capital gain that a scheme can generate can also be impacted by the mutual fund plans that you choose. Every mutual fund scheme is offered in two plans – Direct and Regular. Direct mutual fund schemes can be directly bought through fund houses or even through direct mutual fund investment apps conveniently as these schemes do not involve any commission. On the other hand, regular mutual fund schemes are available for investment through financial products distributors and mutual fund distributor services. For these services, mutual fund distributor services and financial products distributors are paid a commission. Hence, you can see the difference in the total expense ratio and net asset value of both direct and regular plans. These changes in expenses and net asset value can definitely have an impact on the capital gains and the returns that you earn from mutual fund schemes, specifically for the long term.
Choose the right type of funds and the plans suitable for your investment goals to maximize your wealth.