Investors often do not think about tax consequences when making investment decisions. For example, an investor can feel happy if he gets 8 – 9% interest from a fixed deposit scheme. However, if the FD interest is fully taxable, which usually is the case, then the effective post tax return for the investor in the highest tax bracket (30%) is only 5.6 – 6.3%. This return may not be sufficient if you consider the inflation rate. Actually the real return is almost nothing (real return = return earned – inflation).
Most traditional investment options pay fixed interest to investors which are taxed as per the income tax rate applicable to the investor. Sometimes the income is taxable only at the maturity of the investment and at the other times, the income is taxable both during the tenure of the investment and on maturity of the investment. Gold, both in physical form and paper form are taxed as per the income tax rate of the investor, if sold within 36 months of purchase. If gold is sold after 36 months from purchase, then it is taxed at 20% after allowing for indexation benefits. In short, we can say that taxation on Gold is same as that of debt mutual funds.
Therefore, investors should first factor in the effect of taxes on their investments while making investments.
Mutual funds in India, on the other hand, are the most tax friendly investment options for the investors. An important point to note in mutual fund investments is that, an incident of tax arises only when the units of a mutual fund scheme is redeemed. Unlike a bank FD, there is no tax payable by the investor during the tenure of the investment.
Let us now discuss what are the tax benefits of investing in mutual funds in India?
But before that we suggest you to read – what are the advantages and disadvantages of mutual funds in India. We will first start with the tax treatment of equity mutual funds. A mutual fund scheme is considered equity or equity oriented when it has at least 65% equity allocation in the investment portfolios. On the other hand, non-equity mutual funds (debt funds or hybrid equity funds etc.) have less than 65% equity allocation in their investment portfolios.
In this context you may read – What are mutual fund income tax exemption
Long term and short term capital gains in mutual funds
The minimum holding period for calculating long term capital gains (LTCG) in equity funds is one year. Short term capital gains (if the units are sold before one year) in equity funds are taxed at the rate of 15% plus 3% cess. Long term capital gains (LTCG) tax in equity mutual funds is 10%; Capital gains tax @10% is payable on the sale of equity mutual fund units if it is held for a period of more than one year and if the total such gains in a year is over Rs 1 Lakh.
The minimum holding period for short term capital gains (STCG) in debt mutual funds is 3 years. STCG in debt mutual funds are taxed as per applicable tax rate of the investor. So if your taxable income is above Rs 10 lakhs then STCG tax on your debt mutual fund redemption is 30% plus applicable cess and surcharges. Long term capital gains (LTCG) of debt mutual funds are taxed at 20% with indexation.
To calculate capital gains with indexation, you should index your purchasing cost by multiplying the purchasing cost with the ratio of the cost of inflation index of the year of sale and cost of inflation index of the year of purchase, and then subtract the indexed purchasing cost from sales value. Indexation benefits reduce the tax obligation of debt mutual fund investors considerably compared to investments in bank FDs, post office FDs and small savings schemes.
Dividend distribution tax
While dividends paid by mutual funds are tax free in the hands of the investor, the AMC pays dividend distribution tax (DDT) for non-equity mutual funds at the rate of 28.84%. DDT in case of equity or equity oriented mutual funds is only 10% effective 1st April 2018.
The table below summarizes the taxation of equity and non-equity funds.
ELSS tax benefits
Investments in Equity Linked Savings Schemes or ELSS mutual funds qualify for deduction from your taxable income under Section 80C of the Income Tax Act 1961. The maximum investment amount eligible for tax deduction under Section 80C 1961, is Rs 1.50 lakhs. Investors in the highest tax bracket (30%) can therefore, save up to Rs 46,350 in taxes (Rs 1.5 lakhs X 30.9% tax + cess) by investing in ELSSmutual funds.
You may like to read what are tax saving mutual funds
Please note that,Rs 1.50 lakhs is the overall Section 80C limit which includes all eligible items like, PPF, Employee Provident Fund (EPF) contribution deducted by your employer, life insurance premiums, bank or post office tax saving FDs and ELSS mutual funds etc.
We have seen that how investments in mutual fund enjoy significant tax benefits compared to traditional investment schemes. Investors must factor in the effect of taxes while making investment decisions in any scheme and always look at the post tax returns.