Tax Benefits of Investing in Mutual Funds

But how do you decide what is equity fund and what is non equity fund?

A mutual fund is classified as an equity fund or otherwise based on the asset mix. For example, if more than 65% of the AUM of the fund calculated at regular periodicity is invested in equities on an average basis, it is an equity fund for tax purpose. That means; index funds, equity diversified funds, mid-cap funds, small cap funds, balanced aggressive funds, arbitrage funds will all qualify as equity funds for this purpose.

In case, the share of equity is less than 65%, then it is classified as non-equity fund for tax purpose. This would typically include all kinds of income funds, credit funds, MIPs, FMPs, liquid fund and all kinds of Fund of Funds (FOF). Here is a point to note. Even if your fund of funds (FOF) is a fund of equity funds, it will still be classified as non-equity fund for tax purposes.

Can you tell me about the taxation of dividend paid by equity funds?

When you invest in equity funds or debt funds, you can opt for a growth plan or a dividend plan. In case of growth plan, there is no dividend paid out. However, in case of dividend pay-out plan and dividend reinvestment plan, there is a dividend pay-out, either actually or notionally. In such cases, there is a regular dividend paid out and the question is how are these dividends taxed.

In the past, dividends were subject to withholding tax. This applied to equity funds and non-equity funds. Here the withholding tax was deducted by the fund before paying the balance dividend into your bank accounts. This was called the dividend distribution tax or DDT. However, that is not the case any longer. That is because, in the past, the dividends were tax-free in the hands of the investors, both in case of equity funds and debt funds.

Effective the 2020 Union Budget, the government has declared all dividends as taxable in the hands of the investor. Hence whether you earn dividends on equity funds or on non-equity funds, it will be treated as other income in your hands and taxed at your peak applicable rate of tax. Now, since the dividend is taxable in the hands of the investor, there is no need for the fund to deduct any DDT. Hence DDT has been scrapped. Now, any dividend is fully taxed in the hands of the investor at taxed at the peak incremental rate applicable, inclusive of surcharge and cess as applicable.

How are short term and long term determined for equity and debt funds?

The first step here is to classify whether this capital gain is a LTCG (Long term capital gains) or STCG (short term capital gains). This definition again differs for equity funds and for debt funds. In case of debt funds (non-equity funds), a holding period of less than 3 years is classified as STCG while holding beyond 3 years is considered as LTCG. However, in the case of equity funds, the holding period for classification is reduced to 1 year for deciding whether the gain is LTCG or STCG. Therefore, in case of equities, a holding period of less than 1 year is classified as STCG while holding beyond 1 year is considered as LTCG.

Are the capital gains on debt funds and equity funds taxable?

Let us look at debt funds or non-equity funds first. In the case of non-equity funds, the STCG is taxed at your applicable peak rate of tax (20% or 30% as the case may be). In addition, any cess or surcharge will also be applicable. However, in case of LTCG on debt funds, the tax will be charged at 20% on the gains but after considering the benefit of indexation. The Income Tax Act, each year, specifies the applicable index number applicable for each year. You basically arrive at the indexed value of acquisition by multiplying the cost of acquisition by the selling year index and dividing by the purchase year index.

Now let us turn to equity funds. How are equity funds taxed? In case of equity funds, the STCG is taxed at a flat rate of 15%. Obviously, any cess or surcharge will be applicable on top of that but still it is a concessional rate of tax. Regarding LTCG, it was tax-free in the hands of the investor till the Union Budget 2018. However, effective April 2018, the LTCG on equity funds will be taxed at 10% flat without the benefit of indexation, subject to a base minimum exemption of Rs.100,000 per financial year. However, since capital gains will be taxable, the losses can be set off and also carried forward. This is useful in reducing taxes by writing off the losses in profitable years.

Can you clarify on this loss writing off and how it works?

Rule number 1 is that Capital gains can only be set off against capital gains and not against any other income. Further, long term capital losses can only be set off against long term gains. However, short term losses can be set off against STCG and against LTCG.

In addition, there is also the benefit of carry forward. That means, any accumulated capital losses from mutual funds can be carried forward for a period of 8 years and can be written off against future capital gains. A lot of investors do what is called loss farming. Here towards the year end when there are notional losses on a stock or equity funds, they can book the loss, write off against gains and again buy the stock at lower levels. Setting off losses reduces your tax liability as it reduces the taxable capital gains.

Some additional tax benefits of investing in mutual funds

In case of investments in equity linked savings schemes (ELSS) funds, also called tax saving funds, there is an exemption available under Section 80C of the Income Tax Act. The ELSS investments are subject to a lock-in period of 3 years from the date of investment. This exemption of Rs.1.50 lakhs, however, is not exclusive to ELSS. It is an overall blanket limit for a plethora of outlays like ELSS, PPF, LIC, ULIPs etc.

The biggest advantage of mutual funds from a tax perspective is its flexibility. Just take the example of withdrawals. For example, you can avoid the high tax on debt fund dividends by structuring the pay-outs in the form of a systematic withdrawal plan (SWP). These are specifically useful for retirees and others who rely on these income funds for regular income flows.