Investors often do not think about tax consequences when making investment decisions. Many investors do not know if their investment is taxable (or not) and what the taxation rates (if applicable) are. For example, many investors think that, since banks deduct tax at source on fixed deposit interest, they have no further tax obligation on the FD interest. They get a rude shock at the end of the year, when their chartered accountant tells them that they have a substantial tax obligation because the bank deducts TDS at 10% on the interest earned, which is taxable as per the income tax rate applicable for the investor. These investors get a further shock when the CA tells them that, since they did not pay their advance tax in time (4 equal instalments during the year) for the difference between the tax obligation and the TDS, they also have to pay interest on the delayed tax payment.

The point I tried to illustrate through the above example is that, if investors do not understand the tax consequences of their investments, they either end up paying more tax (getting lower returns) than expected or they do not disclose the correct taxable income in the Income Tax Returns (ITR). Not disclosing the correct taxable income can have serious consequences because when the Income Tax authorities come to know of it, the offenders (wilful or otherwise) will not only be required to pay the due tax obligation, but also the penalty and interest thereof; offenders can also be prosecuted and may have to face the legal consequences for tax evasion.

Many a times, investors feel happy if they get 8 – 9% interest rate from a fixed deposit scheme. However, since the interest income is fully taxable, the effective post tax return for the investor in the highest tax bracket is 5.6 – 6.3% only. This return may not be sufficient to keep up with the inflation rate relating to the typical consumption basket of a middle income or upper middle income urban Indian investor.

Taxation of traditional investment options

Most traditional fixed income investment options pay fixed interest to investors which are taxable as per the income tax rate applicable to the investors. Sometimes the income is taxable only at the maturity of the investment and at the other times, the income is taxable both during the tenure of the investment and on maturity of the investment. Interest income from bank fixed deposits and most post office small savings are fully taxable as per the income tax rate of the investors.

Gold, both in physical form and paper form are taxed as per the income tax rate of the investor, if sold within 36 months of purchase. If gold is sold after 36 months from purchase, then it is taxed at 20% after allowing for indexation benefits. Investors should therefore factor in the effect of taxes when making investment decisions.

Profit from real estate, if sold within 3 years, from the date of property purchase, is added to the total income of the investor and taxed as per his / her income tax slab rate. If the property is sold after 3 years from the date of the property purchase, then the capital gains (profits) are taxed at 20% after indexation. However, real investors should remember that, if the property is sold within 5 years of the end of the financial year in which it is purchased, all the Section 80C tax benefits claimed for principal payment is reversed and becomes taxable in the year of sale.

Mutual Funds are the most tax friendly investments

Mutual funds are the most tax friendly investment options available to Indian investors. An important point to note in mutual fund investments is that, an incident of tax arises only upon the sale of units of a mutual fund scheme; there is no tax payable by the investor during the tenure of the investment. Let us now discuss tax benefit on mutual funds.

Taxation of equity funds

From the taxman’s perspective, equity funds are mutual fund schemes which have at least 65% equity allocation in their investment portfolios. Equity fund includes pure equity funds (e.g. large cap funds, diversified equity or multicap funds, midcap funds, index funds, thematic funds etc), equity linked savings schemes (ELSS), balanced funds, equity savings funds, arbitrage funds etc. The minimum holding period for long term capital gains in equity funds is one year only. Short term capital gains (if the units are sold before one year) in equity funds are taxed at the rate of 15% plus 3% cess. Long term capital gains tax in equity funds is zero. Dividends paid by equity mutual funds are totally tax free. Equity funds are much more tax friendly than asset classes like gold and real estate.

See the list of top performing equity mutual funds

Taxation of non-equity funds

Let us now discuss the tax benefit on mutual funds non-equity schemes.From a tax standpoint, non-equity funds are mutual fund schemes which have less than 65% equity allocation in their investment portfolios. Non equity funds include debt funds (including liquid funds), hybrid debt oriented funds (e.g. Monthly Income Plans), gold funds etc. The minimum holding period for short term capital gains in debt funds is three years. Short term capital gains (if the units are sold before three years) in debt funds are taxed as per applicable tax rate of the investor.

Did you know that Liquid Mutual Funds are the best option to park your surplus cash

Long term capital gains (investment tenure of more than 3 years) of debt fund are taxed at 20% with indexation. To calculate capital gains with indexation, you should index your purchasing cost by multiplying the purchasing cost with the ratio of the cost of inflation index of the year of sale and cost of inflation index of the year of purchase, and then subtract the indexed purchasing cost from sales value. Indexation benefits reduce the tax obligation of debt fund investor considerably compared to say investments in bank FDs and many small savings schemes.

For investment tenures of over three years, tax benefit on mutual fund debt funds are definitely much more than bank FDs and post office small savings schemes. Let us illustrate with an example, if a bank pays 7% interest for a 3 year term deposit of Rs 1 lakh, then the tax obligation for the investor in the highest tax bracket (30.9%) will be Rs 6,954 on an interest income of Rs 22,504. If a debt fund gave 7% returns in the last 3 years on the same investment amount, the tax obligation of the investor would have been just Rs 1,834 on the same income.

While dividends are tax free in the hands of the investor, the fund house pays dividend distribution tax (DDT) for non equity funds before distributing dividends to investors. For Resident Indians and HUFs, the Dividend Distribution Tax paid by non equity fund schemes is 25% + 12% surcharge + 3% cess = 28.84%.

Let us now see with a real example how the debt funds are better than that of fixed deposits

Tax savings for Equity Linked Savings Schemes

Investments in Equity Linked Savings Schemes qualify for deduction from your taxable income under Section 80C of the Income Tax Act. The maximum investment amount eligible for tax deduction under Section 80C is Rs 1.5 lakhs. Investors in the highest tax bracket (30%) can therefore save up to Rs 46,350 in taxes (Rs 1.5 lakhs X 30.9% tax + cess) by investing in ELSS. Please note that,Rs 1.5 lakhs is the overall 80C cap after including all eligible items like, your employee provident fund contribution (deducted by your employer), life insurance premiums, ELSS etc.

You may like to read which are the top 6 Mutual Fund ELSS schemes to invest in

Conclusion

Mutual fund investors can get their capital gains statements online from mutual fund registrar and transfer agents like Karvy and CAMS. Your financial advisor can also help you with your capital gains statement. You should mention your capital gains in your income tax returns and pay taxes accordingly. In this article, we have seen the tax benefits on mutual funds are significant compared to traditional investment schemes. Investors should factor in the effect of taxes when making investment decisions.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.