Mutual Funds and Their Tax Benefits

One of the keys to an understanding about mutual funds is to understand the tax benefits and tax implications pertaining to mutual funds. There are different tax implications for different kinds of payouts and also in case of specific mutual funds, there are tax exemptions. Let us look at each of them.

Before getting into the specific tax implications it is essential to understand the classification of equity funds and debt funds for the purpose of taxation. A fund is classified as an equity fund if more than 65% of its AUM is invested in equities. So index funds, equity diversified funds, mid-cap funds, balanced equity funds, arbitrage funds will all qualify as equity funds for this purpose. The rest are classified as non-equity or debt funds and it includes income funds, credit funds, MIPs, FMPs, liquid fund and all kinds of Fund of Funds (FOF). Now for the tax implications.

Tax Implications of Dividends paid out

When dividends are paid out, the first thing that needs to be remembered is that the dividends are tax-free in the hands of the investor in case of equity funds and debt funds. However, in both the cases, the dividends will attract dividend distribution tax (DDT). In the case of debt funds, the dividend distribution tax will be deducted at 25% plus applicable surcharge and the health and education cess. Only the net amount is paid out as dividends. In case of equity funds, the dividend did not attract DDT till last year. Effective April 2018, all dividends distributed by an equity fund will be subjected to 10% DDT. In addition, the surcharge and the cess will also apply.

Tax implications on short term and long term capital gains

This is perhaps the most comprehensive taxation to be understood. For capital gains, you need to first classify the gains into LTCG or STCG. In case of debt funds, a holding period of less than 3 years is classified as STCG while holding above 3 years is considered as LTCG. In case of equity funds, the holding period of 1 year is the cut-off for deciding whether the gain is LTCG or STCG. Let us look at how they are taxed.

In case of debt funds, STCG is taxed at your applicable peak rate of tax (20% or 30% as the case may be). In case of LTCG, the tax will be charged at 20% on the gains but after considering the benefit of indexation. This reduces the tax liability substantially. In case of equity funds, the STCG is taxed at a flat rate of 15%. LTCG was tax-free till last year. However, effective April 2018, the LTCG on equity funds will be taxed at 10% flat without the benefit of indexation. That makes the cost quite steep, especially in case of very long-term holding periods. In case of resident Indians there is no tax deduction at source (TDS) for equity funds or for debt funds. However, in case of NRIs, the fund is required to deduct TDS before paying out the redemption proceeds to the NRI.

What about losses and carry forward of losses?

Capital gains cannot be set off against another head except capital gains. For example, long term capital losses can only be set off against long term gains. However, short term losses can be set off against STCG and against LTCG. Any accumulated capital losses from mutual funds can be carried forward for a period of 8 years and can be written off against future profits. In fact, when you are approaching the year end and have book losses then you can convert them into actual losses to get the benefit of a write-off. It reduces your total tax liability to that extent.

Are there are any special benefit schemes in mutual funds?

There have traditionally been two specific mutual fund schemes wherein the investor can get special exemption benefits. In case of investments in the equity linked savings schemes (ELSS) funds, there is an exemption available under Section 80C of the Income Tax Act. This is subject to a lock-in period of 3 years. This exemption of Rs.1.50 lakhs is a blanket limit which includes ELSS, PPF, LIC, ULIPs etc. The overall limit of Rs.1.50 lakhs does not change. You get a 30% tax exemption on your ELSS contribution (depending on your tax bracket). This can substantially enhance your effective yield. In the last few budgets there have been calls for reintroducing Section 54EF benefits for reinvestment of capital gains into mutual funds with lock in. That has not seen much progress!