Tax implications of mutual funds
Investing in mutual funds for the short- and long-term, in both debt and equity mutual funds, have different tax implications. A mistake could seriously impact returns. A complete guide.
The eventual returns from any investment, not just mutual funds, depend partially on how they are taxed. If you make investments without understanding the tax implications, you may be surprised by how your returns fall after tax is calculated. The mutual fund industry comprises equity and debt investments, which are further divided into growth and dividend options. Picking one of these investments without understanding their tax implications could seriously affect your returns. Dividend debt schemes, for example, are taxed at 28.325%, no matter which tax bracket you’re in. That’s why we’ve got a table so that you can easily tell if you’re putting your money in a tax efficient scheme.
Debt vs equity:
It’s crucial to understand how taxes on capital gains work in the mutual funds context. If you’re new to the concept, a capital gain is any profit on the sale of certain investments, such as mutual funds (only growth) and shares. When a capital gain is earned, tax must be paid, depending on the time for which the investment was held. The rate differs for equity and debt schemes for the short- and long-term. Here’s how it works:
Short-term equity: You will have to pay tax of 15% on your return. So if Rs10,000 is your capital gain, Rs1500 would be the tax you will have to pay.
Long-term equity: You pay no tax in this case. This is why equity mutual funds are such favourable investments for the long term.
Short-term debt: You are taxed at your slab rate. If your income falls in the 20% tax bracket, for example, you must pay tax at this rate.
Long-term debt: You can pay tax of 10% of your gain or pay 20%, but with indexation. Indexation basically adjusts your earnings for inflation. Find out how to do this here.
Dividend vs growth plans:
If you’re checking net-asset values of dividend and growth schemes, you’ll notice that they differ. The dividend schemes would have a lower NAV because they are taxed by the fund house and returns are paid out periodically. With growth schemes, the NAVs are higher because profits are booked only at the time of sale and the fund house does not tax the amount at the source. Here’s how these schemes are taxed:
Equity schemes: There is absolutely no tax on equity dividend schemes. This applies at the time of sale as well as to the dividends.
Debt schemes: These schemes are taxed by the fund house, as stated above. The fund house must pay Dividend Distribution Tax at 28.325% prior to distributing the funds. Thus if you are investing for a short term and fall within the highest tax bracket of 30% it would be cheaper for you to opt for a dividend plan rather than a growth plan.
To sum it all up in a single picture:
*STT will be deducted at the time of sale of units/switch to another scheme
** Under 12 months
Therefore, here are just two tips for lowering your tax liability on mutual fund investments:
If you’re investing in equity, you should pick the dividend option if you believe you will be redeeming your units in under a year. This is because short-term capital gains on growth schemes is 15%, but nil on dividend schemes.
If you’re investing in debt, go for the growth option as the fund house would deduct DDT of 28.235% irrespective of the tax bracket you’re in. However, if you’re in the highest tax bracket and plan to sell off your investment within a year, the dividend option would be marginally beneficial from a tax perspective.