What are mutual fund tax benefits

As you may know there is an old saying that there are only two certainties in life - death and taxes; death is unavoidable, but taxes can be reduced significantly under certain circumstances, provided you understand the tax laws well and make the right investment moves. Unfortunately, many of us do not understand the tax consequences of our investments and the result is that we either end up paying more taxes than expected or we do not disclose the correct taxable income while filing the Income Tax Returns (ITR). Paying more taxes also means that our post tax returns are less.

Mutual fund tax benefit makes it one of the most tax friendly investment options for investors in India. Mutual Funds enjoy tax benefits compared to most of the popular traditional investment options e.g. bank fixed deposits, PPF, Post Office small savings schemes etc. These traditional investment options are taxed as per the income tax slab rate of the investor.

However, different types of mutual funds are taxed differently, depending on the nature of income and type of the scheme.

Capital gains on Mutual Funds

Capital gain is the profit made by sale of mutual fund units; profit is the difference in the selling price and buying price of mutual fund units. From a taxation point, there are two types of capital gains.

  • Short term capital gain: The definition of short term capital gains is different for equity funds and non-equity funds. A fund in which invests at least 65% of it's assets to equities or equity related securities is classified as an equity fund. Funds, where equity allocation is less than 65% of the total assets, are classified as non-equity funds from a tax perspective. If the equity funds are sold within 12 months from the date of investment, then the profits arising from these sales are treated as short term capital gains. For non-equity funds, short term capital gain period is defined as, within 36 months from the date of investment.

    For equity mutual funds, short term capital gains (if the units are sold before one year from date of investment) are taxed at the rate of 15% plus 3% cess.

  • Long term capital gain: If the units are sold after a period defined under tax laws, then it leads to long term capital gains. For equity funds long term capital gain period is defined as, more than 12 months from the date of investment. There is no long term capital gains tax in equity funds; in other words, there is no tax on the profit from sale of equity fund if units were held for a period of more than one year.

    For non-equity funds long term capital gain period is defined as, more than 36 months from the date of investment. Non-equity funds are taxed as per the income tax slab rate of the investor. Long term capital gains in debt funds (if units are sold after 36 months from the date of investment) are taxed at 20%, after indexation benefits. 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. So for long term debt investors (investment tenure of more than 36 months), debt mutual funds give more tax benefits for investors in the 20% or higher tax brackets compared to traditional investment schemes which is taxed as per the income tax slab rate of the investor.

    You can check how debt mutual funds are better alternative to fixed deposits

Dividends on Mutual Funds

Dividends are another mutual fund tax benefits for which investors invest in mutual funds. Dividends are profit made by a mutual fund scheme and distributed to the investors. While dividends of mutual funds are tax free in the hands of the investors, for equity funds the dividend distribution tax is zero even for the fund house. Hence, over short investment tenures (less than 12 months), dividend or dividend re-investment options can offer more tax benefits than growth options (where short term capital gains tax apply) for equity or equity oriented funds.

For non-equity funds, like debt funds, money market mutual funds, hybrid debt oriented funds, gold funds etc., while dividends are tax free in the hands of investors the AMC has to pay dividend distribution tax (DDT) before distributing dividends to investors. The dividend distribution tax (DDT) on dividends declared by debt mutual fund schemes is 25% plus 12% surcharge plus 3% cess, total 28.84%. For fixed income investors in the highest tax bracket (30%), dividends, even after paying the dividends distribution tax is more tax efficient, compared to interest incomes from traditional fixed income schemes, which are taxed as per the income tax slab rates of investors.

Conclusion

Mutual funds tax benefits make mutual funds among the most tax efficient investment options for investors. Investors should educate themselves about the tax benefits of mutual funds vis- a-vis other investment options, so that they can make the best investment decisions by investing in the mutual funds and avail tax benefits.

To know more, you may like to read - The tax benefit of mutual funds versus other investment options