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In a mutual fund, you make returns in two ways. How are mutual funds taxed for each of these ways? It depends on the nature of return. 

How are mutual funds taxed
  • Capital gains: This is the difference between your purchase NAV and the redemption NAV. For example, if you bought mutual fund units for Rs 15 and redeemed it for Rs 20, your capital gains per unit is Rs 5. Only capital gain that is booked is taxed – i.e., you will be taxed only at the time of selling your units. Your gains on paper are not taxed as long as you do not sell any unit.  
  • Dividends: Mutual funds pay dividends from time to time. This dividend is stripped from your NAV and given to you. 

Capital gains tax rates and rules 

Equity and equity-oriented funds

Categories covered: Pure equity funds such as large-cap, multi-cap, sector, thematic, index and so on, and hybrid equity-based funds – arbitrage, balanced advantage, equity savings and aggressive hybrid

Short-termLong-term
Holding periodLess than 12 months12 months and longer
Tax rate15%10%
ExemptionsCapital gain up to Rs 1 lakh from all equity investments (including stocks) each fiscal year is tax-free

All other funds

Categories covered: Pure debt funds, international funds, gold funds, debt index funds, hybrid funds that are not equity-oriented such as conservative hybrid

Short-termLong-term
Holding periodLess than 36 months36 months and longer
Tax rateAt your income tax slab rate20% with indexation benefit

Note: This tax treatment is for resident Indian investors only. For NRIs, please click here <LINK> for tax rules.

What is an equity-oriented fund?

An equity-oriented fund is one which invests at least 65% of its portfolio in domestic stocks. Therefore, international funds, while investing in stocks will not qualify as equity-oriented as they don’t hold domestic stocks. 

For investments in equity-oriented funds prior to January 31st 2018

Tax rules for such investments are different, as long-term capital gains until this date were tax-exempt. The 2018 Budget brought in long-term capital gains tax on equity and to remove retrospective impact, it grandfathered gains made up until that date. 

That is, if you invested in equity-oriented funds before January 31 2018, capital gains you made until then is exempt from taxes. You will pay tax only on gains made post this date. In order to work this gain out, you need to calculate the cost of investment using the following method:

Calculating cost for pre-Jan. 31, 2018 investments
Step 1Take the actual NAV at which you invested. Call this Value 1.
Step 2Compare the NAV on January 31st 2018 and the NAV at which you redeemed. Take whichever NAV is lower. Call this Value 2.
Step 3Compare Value 1 and Value 2. Take whichever NAV is the highest. This is the cost of acquisition for taxation purpose.

Your capital gain is the difference between the Step 3 cost of acquisition and the actual NAV at the time of redemption.

For example, say you invested at an NAV of Rs 22 in December 2016. Its NAV as on Jan 31st 2018 was Rs 25, and you sold it in March 2020 at an NAV of Rs 28. In this case, value 1 is Rs 22, and value 2 is Rs 25 (lower of Rs 25 and Rs 28). So the cost of acquisition works out to Rs 25 (higher of Rs 22 and Rs 25). Your capital gain per unit is Rs 3 (Rs 28 less Rs 25).

Dividend tax rules – all mutual funds

The 2020 budget made sweeping changes to dividend taxes for mutual funds (and stocks!). Up until then, dividend distribution tax (DDT) was applied on dividend paid and the net proceeds were returned to you. Both equity and non-equity funds came under the DDT net. You did not have to pay dividend taxes separately.

From the fiscal 2020-21 and onwards, DDT won’t be applied. All dividend received from mutual funds, whether debt or equity-oriented, will be taken as your income and added to your total income. You will then pay tax on this based on your slab rate. You will therefore need to keep track of dividends received.

If you have opted for dividend reinvestment, do keep in mind that it still counts as income earned in the year. All you’re doing is reinvesting this income earned. You will need to include this as well when working out total dividend received in a year.

Taxation when investing through SIP or STP

You can invest in the same mutual fund on different dates, especially when you are invest through SIPs. In this case, how is the capital gain and tax calculated? The tax rules follow a first-in-first out logic. That is, it is assumed that the first unit you bought is the first unit you sold. See the example below to understand it better:

DateNAVNo. of units investedInvestment costCumulative no. of units
15-Jun-1536.621375,017 
06-Dec-1530.22661,995203
24-May-1631.69953,010298
18-Dec-1635.801686,014466
29-Apr-1726.661885,012654
25-Aug-1727.131473,988801
05-Mar-1850.2819910,0061,000
27-Jul-1842.39713,0101,071
03-Jan-1946.89219851,092
15-Mar-2044.821125,0201,204

Say that you sold 500 units today at Rs 50 per unit. Your redemption amount is then Rs 25,000. 

The first units bought are in June 2015. That’s 137 units. Then go to the next purchase date, in December 2015. That’s a further 66 units to total 203 units. Move date-wise in such a manner until you arrive at the 500-unit total. So for 500 units, you will have to include all investments made from June 2015 to December 2016, and 34 units of bought on April 2017. The total cost of these investments is Rs 16,942. For non equity-oriented funds, you will have to calculate the indexed cost for each of the dates to arrive at the total cost. You don’t need to really sweat this out! These details are mostly available as statements if you invest through online portals.

For more about mutual funds and how they work, please refer to this article.

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A good guide on mutual fund taxation can be found here.

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