Are Mutual Funds Tax Free or Taxable?

Last Updated : Aug. 9, 2017, 6:15 p.m.

Mutual funds are on its way to rule the investment sector as other products like fixed deposits, savings account, gold, etc. are not giving good returns and are on the verge of losing their charm. Nowadays, people look for the options that can get them maximum returns and mutual fund investments are one of the best choices available to them. But, no matter how much we earn, we want to save on tax and most of us are confused whether the income from mutual fund is taxable or not. It is thus important to know that the returns earned from mutual funds are taxed under the ‘Income from Capital Gains’. The capital gains can be short-term or long-term based on the holding period of investment. Also, the tax rates applicable to both short-term and long-term type of investments is different along with the variability in the capital gains rules for equity and non-equity schemes. The functioning of mutual funds depends on the needs and expectations of the investor. Also, the taxation on each type of fund is also different. In this article, we will talk about the mutual funds that are tax-free and also the ones that are taxable. But first here are the objectives of mutual funds that you must know as a basic understanding of the types of mutual funds.

Objectives of Mutual Funds

• Equity (Growth) – In this product, the investment is done only in stocks.
• Debt (Income) – Here the investment is done only in fixed-income securities.
• Money Market (Including Gilt) – Under this fund, the investment is done in short-term market instruments including government securities.
• Balanced – As the name suggests, the balance is maintained and hence the fund is put partially in stocks and partly in fixed-income securities.

Does Mutual Funds Comes under section 80c

We are always looking for options that can help save tax. While on the one hand, it is important to have the proper knowledge of the various tax-saving provisions under the Income Tax Act, it is equally important to know the major tax saving instruments that let you benefit from these provisions. One such provision is the Section 80C Act of the Indian Income Tax Act 1961, an individual can save tax. Under this section, the investments up to ₹1,50,000 per annum are eligible for deduction from the taxable income. As an investor, you can plan to utilize this benefit to the fullest by investing in some of the instruments based on the factors like the financial needs and goals, the risk appetite, etc. ELSS is a dedicated mutual fund scheme that allows you to save tax and also gives you the opportunity for long term capital appreciation. With the help of an ELSS fund manager, you can create your own diversified portfolio, focusing on the equity and equity related instruments that carry high-risk along with the potential for high returns. Since equity funds are based on the market, the returns from this scheme are market determined and hence is for the investors who are comfortable in taking high-risk.

Tax on ELSS funds

Talking about the income tax on mutual funds redemption, ELSS is the best investment tool. Since an ELSS falls under Section 80C, you can claim up to ₹1,50,000 per annum from your investment as a deduction from your gross total income. The returns from an ELSS fund are tax-free and the long term capital gains from it are also tax-free. The reason behind is that no tax is levied on equities that are held for more than a year. Below are the features of ELSS funds that you must know and the benefits they have.

Features of ELSS funds

• Tax-saving
• 3-year lock-in period
• Can be held even after the completion of three years
• Option both dividend and growth funds
• Tax Saving instruments

Benefits of ELSS fund

Even though there are other tax saving schemes, ELSS still holds great importance. The reasons are as follows:

• The lock-in period is lower- As compared to other tax saving schemes like Tax Saving fixed deposits where the lock-in period is 6 years and PPF where the highest lock-in period is 15 years, ELSS has a lower lock-in period of only three years.
• Opportunity for Long Term Capital Gains- ELSS fund is managed by professional fund managers and the investment is done in the equities and hence has the potential to provide long term capital gains.
• Systematic Savings- With the ELSS fund, you can plan effective investment through SIP (Systematic Investments Plans) instead of the sudden last-minute lump-sum investments.

Tax on Equity Mutual Funds

A mutual fund scheme is eligible to be taxed as an equity scheme if the investment amount is at least 65 per cent of the total corpus in equity and equity related instruments. Also, if investments are held for more than a year, only then the return from an equity mutual fund is considered as long term capital gain. This return is completely exempted from income tax. But, if the investments are done for a year or less, the returns are taxable at 15 per cent under short term capital gains.

Tax on Debt Mutual Funds

Debt mutual funds fall under the category of non-equity funds for the purpose of taxation wherein the mutual fund schemes invest less than 65 per cent of the corpus in equity. In addition to debt mutual funds, gold funds, fund of funds, international funds, etc are also categorised as non-equity schemes for the purpose of taxation. The returns are taxed at 20 per cent with the indexation benefit from non-equity funds are considered as long-term capital gains only when the investments are held for more than three years. Indexation is a procedure of inflating the purchase cost to account for inflation with the help of a price index. This process helps in reducing the taxable profits but when the investments are held for three years or less than three years, the returns are treated as short-term capital gains which are accounted as the income and hence taxed as per the income tax rate applicable to the investor based on his income.

Tax on Dividend from Debt Mutual Fund

The investors who have invested in a mutual fund scheme under the dividend option are free from taxation. Since dividends are exempt from the income tax for both equity and debt schemes. But, mutual fund houses do have to pay the tax which is Dividend Distribution Tax of on dividends under debt schemes. Hence, the dividends from debt funds are taxed.

Disclaimer – Mutual Funds are subject to market risks. Please read the scheme related documents carefully before investing.