TomorrowMakers

This article attempts to provide a comprehensive view of the tax implications of mutual funds.

What are the income tax implications of selling or switching mutual funds

Mutual funds are considered to be tax-friendly investments compared to other instruments. However, many investors are unaware of the tax implications of mutual funds. Such implications arise on the sale of mutual fund units or switching of mutual fund units from one scheme to another. Being aware of the tax implications will help investors in making an informed and conscious decision. 

Let us understand the concept of capital gains tax first before we delve into the details.

When does capital gains tax arise?

A capital gain arises when the mutual fund is sold at a NAV higher than that of its cost price (NAV at the time of purchase). Capital gains should be filed for in the year in which it arises. The tax implication is levied on capital gains after adjusting capital losses (if any).  

Switching or systematic transfer from one fund to another also involves redemption and re-entry into another fund. This would also have a tax implication, the fund from where the exit has happened will be considered as redemption. 

What is the implication of capital loss?

If the mutual fund sale has resulted in a capital loss – that is, the sale price (NAV on the date of sale) is lower than the purchase price (NAV on the date of purchase) – the same can be set off against any capital gains derived during the year. Both short-term and long-term capital loss can be carried forward for eight assessment years after the year in which the capital loss arises. Only the loss in excess after adjusting against current years capital gain can be carried forward. 

Related: 6 Reasons why you should invest in mutual funds

What is a holding period?

  • Equity mutual funds: The holding period is an important aspect in the assessment of capital gains. If the period is more than 12 months, any capital gains/loss would be termed as long-term. If the holding period is 12 months or less, the capital gains/loss would be considered short-term. Different tax rates are applicable based on the category.
  • Debt mutual funds: A holding period of 3 years or lower is considered as short-term capital gains in the case of debt mutual funds. If the mutual funds are held for a period greater than 3 years, they will be assessed as long-term capital gains. 

Income tax implications on equity mutual funds

Equity mutual funds are those funds that have an underlying exposure in equity to the extent of at least 65%. Below is a tabular representation of the tax implication on equity mutual funds:

Equity mutual funds Short-term capital gains  Long-term capital gains
Holding period < 12 months > 12 months
Tax implication 15% + 4% cess = 15.60% 10% + 4% cess = 10.40% (if the long-term gain exceeds Rs 1 lakh in a FY)

If the equity mutual funds are held for 12 months or less, the tax is assessed under short-term capital gains and the tax rate would be 15% + 4% cess. If the equity mutual funds are held for 12 months or greater, tax is assessed under long-term capital gains and the tax rate would be applied at 10% + 4% if the long-term capital gains exceed Rs 1 lakh.

Dividends on equity mutual funds are not taxable in the hands of the investor. Instead, a dividend distribution tax (DDT) is payable by the mutual fund house. The DDT for equity mutual funds is charged at 10% + 12% surcharge + 4% cess = 11.648%. However, as indicated earlier, it is tax-free for the investor. 

Related: Best mutual funds for investment in 2021

Income tax implications on debt mutual funds

Debt mutual funds are those funds that have a minimum of 65% exposure in debt or debt-related instruments such as call money, bonds, T-bills, fixed deposits etc. The holding period threshold is 3 years in the case of debt mutual funds. See the table below for details on capital gains applicable:

Debt mutual funds Short-term capital gains  Long-term capital gains
Holding period < 36 months > 36 months
Tax implication As per tax slab applicable For the highest tax slab it is 30% + 4% cess = 31.20% 20% with indexation

Dividends are not taxable in the hands of the investor; a dividend distribution tax (DDT) is payable by the fund house. The DDT for debt mutual funds is charged at 25% + 12% surcharge + 4% cess = 29.120%. 

Tax deduction under section 80C

Under section 80C of the Income Tax Act, 1961, investment in equity-linked savings schemes (ELSS) is allowed within the maximum limit of Rs 1.5 lakh. ELSS is allowed alongside other investment avenues such as employee provident fund (EPF), public provident fund (PPF), national savings certificate (NSC), life insurance premiums, etc.

To sum up, the income tax implications should be a key consideration while investing in mutual funds, especially when it comes to selling or switching them.