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Mutual funds

Types of Mutual Funds and their Taxation

mutual-fnd
A) Types of Mutual Funds
Broadly, Mutual Funds are categorized into types of Funds:

  • Equity Mutual Funds
  • Debt Mutual Funds

B) Types of taxation on MF:

  • Tax on Income/ dividend distribution by a scheme
  • Tax on Capital Gain/ Loss from the redemption of MF units.

Before we discuss on the taxes on MF, let us first understand the meaning of Equity Fund or a Debt Fund.

Equity Mutual Fund: In such Funds, more than 65% of the investment corpus of a fund is invested by way of equity shares in Indian companies. So, sometimes, even a Balanced Fund (which comprises of both Equity + Debt) is categorized in this category.

Debt Mutual Fund: All the other Funds that do not fit in the category of Equity Mutual Funds will fall under this category. This even includes Fund of Funds (i.e. Mutual Funds that invest in other Funds) and International Funds (i.e. Mutual Funds that have more than 35% of investment in foreign equities)
Mutual Fund
Capital Gain Tax on Equity Mutual Funds
a) Long Term Capital Gain: If MF is held for more than 1year, it is categorized as Long term Capital Asset. In this case, at the time of redemption, the entire value appreciation is Tax Free as per section 10(38) of Income Tax Act.

b) Short Term Capital Gain: If on the other side MF is sold within one year, it will be categorized as Short Term Capital Gain, and the appreciated amount will be taxed @15% as per section 111A of Income Tax Act.

c) In case of NRIs holding MF, LTCG is tax free and on STCG TDS shall be deducted @ 15% by the MF Company before redemption.

d) In case the unit holder receive any dividend income from Equity MF, the dividend income is completely tax free both in the hands of person receiving the dividend and the person paying the dividend.

Capital Gain Tax on Debt Mutual Funds

a) Long Term Capital Gain: If MF is held for more than 3 years, it is categorized as Long term Capital Asset in case of Debt Fund. In this case, at the time of redemption the Long Term Gain will be taxed @ 20% (plus 3% cess) after claiming the indexation benefit or 10% (plus 3% cess) without indexation.

b) Short Term Capital Gain: If on the other side MF is sold within 3 year of acquisition, it will be categorized as Short Term Capital Gain, and the capital gain amount will be included in investor total income and shall be charged at the rate according to the tax slab.

c) For NRIs, the STCG will be taxed @30% (plus 3% cess) and LTCG will be charged @20% (plus 3% cess). However, in both the cases, TDS shall be deducted by the MF Company before sell/redemption of MF units.

d) In case the unit holder receive any dividend income from Equity MF, the dividend income is completely tax free in the hands of person receiving the dividend but the person paying the dividend has to pay dividend distribution tax before giving the dividend.

FDs v/s Mutual Fund Investment

A) Time Period for Investment

Whether you should invest in bank FDs or MF, foremost thing is to decide your term of investment. If you are planning to go for a short term investment, our advise would be to better put your money in FDs, as you will get an assured return after maturity (say 8% – 9% as of now). However, if you aim to invest for a longer period (say more than 3 to 5 Years) you should better go for investments in Mutual Funds. If a correct MF is chosen, return can also reach upto more than 100%. A correct investment advisor can help you reach your financial goal by helping you choose the correct fund.
B) Capital Safety

Mostly people are worried that their capital should not get depleted at any cost in any given point in time and so a general public goes for putting their hard earned money in Bank FDs. However, if you are ready to take a risk of few percent, with a right investment advisor you can earn many more times of return than bank. So, think first what kind of investor you are.

C) Liquidity

Debt fund offers more liquidity to your money compared to FD
D) Tax on returns

This point is the most important to be kept in mind while planning your financial goal. You earn Interest on FD while you earn capital apprehension or Dividend income from Mutual Fund Investment. Consider the below points to understand the tax impact on the two:

  • Bank FDs are taxed at your maximum rate, however return from equity MF is free after 3 years.
    Most hurting point is, in case of investment in FDs, tax needs to be paid even on accrued interest (interest that is earned but not actually received), whereas there is no such charge in MF income.
  • Consider the impact of compunding on the return arrived after paying tax, hence this sounds less but the impact is huge, when talking aabout long term one should not forget the time value of money.

For eg: Say, The rate of return is 15% and the value invested is Rs100 is invested for 20 years with tax rate of 33.99% (after applying surcharge and cess on 30% tax)

Case 1 Tax free investment
Case 2 Taxable investment

Value of Rs 100 at the end of each year

No. of year Tax Free (Case1) Taxable (Case 2) Cost of Tax
1 115 110 5
2 132 121 11
3 152 133 19
4 175 146 29
5 201 160 41
10 405 257 147
15 814 412 402
20 1637 661 976

So this is the power of compounding, which can never be ignored.

To conclude, if you are planning to invest for long term, go for equity MF and choose the best MF available in market, however, if your goal is short-term, better go for Bank FDs.

There are various types of MF available in the market, like Debt MF, money market and liquid schemes etc. Of these which type is beneficial for what type of investor and in what time frame, is dealt in another blog.