How your mutual fund investments are taxed

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The tax impact is much lower in case of LTCG on debt funds and equity funds. In case of debt funds, there is an indexation benefit available that reduces the taxable gain.

Mutual fund taxation needs to be understood at three levels. Firstly, there are tax implications on the dividends received on mutual funds. Secondly, tax implications on the capital gains or losses that arise from mutual funds when they are sold. Lastly, there is the special case of ELSS mutual funds that provide tax exemptions for the amount invested during the year.

Taxation of dividends

Mutual funds have growth plans and dividend plans. The taxation of dividends will depend on whether it is an equity fund or a debt fund. For the purpose of taxation, a mutual fund is classified as an equity fund if minimum 65% of the AUM of the fund is invested in equities or else it is classified as non-equity (debt) funds. Here are two things to remember about taxation of dividends.

In case of equity funds, the dividends are tax-free in the hands of the investor. That has not changed. However, Union Budget 2018 has imposed a dividend distribution tax (DDT) on equity mutual fund dividends at 11.648% (surcharge and cess included). This will reduce the in-hand return to investors.

In case of debt funds, there is no change in the taxation methodology. Dividends continue to be tax-free in the hands of the investor but the DDT on debt fund dividends will continue at the rates of 29.12% (surcharge and cess included).

Capital gains

Capital gains on mutual funds arise when profits are realised at the time of sale of mutual fund units. Capital gains are of two types; long-term capital gains (LTCG) and short-term capital gains (STCG). In case of equity funds, the cut-off for LTCG is 1 year holding while in case of debt funds the cut-off is a holding period of 3 years. Union Budget 2018 has made a significant change in the tax on LTCG of equity funds. What was tax-free till now will be taxed at 10% above gain of `1 lakh per annum and without the benefit of indexation. All gains until January 31, 2018 have been “grandfathered”. So you can assume the new cost of holding your equity mutual funds is the closing price on January 31, 2018. The start date of your holding remains the original purchase date.

The tax impact is much lower in case of LTCG on debt funds and equity funds. In case of debt funds, there is an indexation benefit available that reduces the taxable gain. In case of LTCG on equity funds, the exemption of `1 lakh of capital gain reduces the tax impact. One must also remember that any losses can be written off against accumulated losses of the same category and such losses can also be carried forward for eight assessment years.

Section 80C benefits on ELSS

This is a special benefit that is conferred on a specific category of funds called ELSS (Equity Linked Savings Schemes) funds. ELSS funds entail a mandatory lock-in period of three years. Investments in ELSS are eligible for tax exemption under Section 80C up to `1.5 lakh for a fiscal year. Such investments in ELSS will be clubbed along with other assets eligible under Section 80C like PPF, life insurance, home loan principal, etc. This exemption reduces your effective tax in the year and enhances your returns on the fund.

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