Capital Gains Tax
The capital gains earned on mutual funds attract taxes. Depending on the duration, capital gains can either be short-term or long-term. In this article, we will be explaining what capital gains tax is, how you can calculate it, and how you can reduce your tax burden when investing in mutual funds in India.
What Is Capital Gains Tax?
Before we learn what capital gains tax is, we should understand what capital gains are. Generally, capital gains refer to the gains or profits an individual makes on the sale of any capital assets. These could either be financial or non-financial assets.
Financial assets are those that are non-physical or intangible in nature such as bonds, stocks, deposits, mutual funds, etc., Meanwhile, non-financial assets can be any physical item, which ranges from property, automobiles, etc.,
For example, You bought a house for ₹75 lakhs in October 2014. The full value of consideration in the financial year of 2017-18 was ₹2.1 crore. The house was held for more than 24 months, and hence, it is deemed a long-term capital asset. After considering the cost of improvement, and considering inflation, the cost price was adjusted, and the indexed cost of acquisition was also taken into account. The adjusted cost of the property was then settled at ₹1.4 crores.
This means you have accumulated a net capital gain worth ₹65 lakhs. After a long-term capital gains tax rate of 20% was levied on the net capital gain, the tax liability that was calculated to be paid would be around ₹13 lakhs. But there are also exemptions that are provided by the tax authorities which can offset the gains and the amount of tax to be paid if managed in the right way.
What Are The Types Of Capital Gains Taxation?
Based on the holding period, capital gains can be classified into the below two categories.
- Short-Term Capital Gains (STCG)
Any asset that is held for less than 36 months is termed a short-term asset. In the case of immovable properties, the duration is 24 months. The profits generated via the sale of such an asset would be treated as short-term capital gain and it would be taxed accordingly.
- Long-Term Capital Gains (LTCG)
Any asset that is held for more than 36 months is termed a long-term asset. The profits generated via the sale of such an asset would be treated as long-term capital gain and it would attract tax accordingly.
What Are The Types Of Capital Gains Taxation On Mutual Funds?
Capital gains in mutual funds refer to any profit or gains that the investors make on the sale or redemption of their mutual fund investment units.
Short-Term Capital Gains On Mutual Funds
Generally, short-term capital gains with respect to mutual funds, are the gains or profits an investor makes on the sale of their mutual fund investments if the holding period is less than twelve months. However, short-term capital gains can be acquired in both equity mutual funds and debt mutual funds.
STCG For Equity Mutual Funds - If an investor makes a profit on the sale or transfer of their equity mutual fund units before one year, the profits are termed as short-term capital gains.
STCG For Debt Mutual Funds - If an investor makes a profit on the sale or transfer of their debt mutual fund units before the completion of three years, the gains are termed short-term capital gains.
Long-Term Capital Gains On Mutual Funds
Long-term capital gains with respect to mutual funds are the gains or profits an investor makes on the sale of their mutual fund investments if the holding period is longer than twelve months. Just like short-term capital gains, long-term capital gains can also be acquired for both equity mutual funds and debt mutual funds.
LTCG For Equity Mutual Funds - If an investor makes a profit on the sale or transfer of their equity mutual fund units that we held for over one year, the gains are termed long-term capital gains.
LTCG For Debt Mutual Funds - If an investor makes a profit on the sale or transfer of their debt mutual fund units that we held for more than three years, the profits are termed as long-term capital gains.
What Are The Taxation Of Capital Gains On Different Types Of Mutual Funds?
We have explained how both long-term and short-term capital gains are taxed on mutual funds. Now, we will explain how capital gains are taxed for different types of mutual funds.
Taxation Of Capital Gains Of Equity Mutual Funds
Equity mutual funds invest 60% of their assets in a variety of companies in suitable proportions. The asset allocation will be in line with the investment objective. The assets will be allocated purely in stocks of large-cap, mid-cap, or small-cap companies, depending on the market conditions.
Short-Term Capital Gains Tax
When you redeem your investments from equity mutual funds within one year, the short-term capital gains are taxed at a flat rate of 15%, irrespective of your income tax bracket.
Long-Term Capital Gains Tax
If you redeem your investments from equity mutual funds after a holding period of one year or more, you will be subject to long-term capital gains tax. Capital gains of up to ₹1 lakh a year are exempted from tax. If your long-term capital gains exceed this limit, you will have to pay the LTCG rate at the rate of 10%, with no benefit of indexation.
Taxation Of Capital Gains Of Debt Mutual Funds
Debt mutual funds are mutual fund schemes that invest predominantly in fixed income-generating securities like Commercial Papers (CP), Certificates of Deposit (CD), Corporate Bonds, T-Bills, government securities, and other money market instruments. These instruments have a fixed maturity date and interest rate, which the buyers could earn until the maturity of the security. Debt mutual funds are considered to be less volatile than equity funds.
Short-Term Capital Gains Tax
When you withdraw your investments from debt mutual funds within a holding period of three years, the gains you receive are called short-term capital gains. These gains are added to your taxable income and taxed at your income tax slab rate.
Long-Term Capital Gains Tax
When you withdraw your investments from debt mutual funds after a holding period of three years, the gains you receive are called long-term capital gains. These gains are taxed at a flat rate of 20% after indexation. Post this, applicable cess and surcharge will also be levied on your tax.
Taxation Of Capital Gains Of Hybrid Mutual Funds
Hybrid funds are mutual fund schemes that invest in more than one asset class (i.e.) equity, debt, and other asset classes depending on the scheme's investment objective. These funds invest in a combination of different asset classes for diversifying the portfolio in order to minimize the risk. These funds have the potential to generate relatively better returns than debt mutual funds. However, they are not riskier than equity mutual funds.
The way in which hybrid funds or balanced funds are taxed is dependent on the equity exposure of the portfolio. If the equity exposure is over 65%, the fund will be taxed like an equity fund, if not, it will be taxed like a debt fund. Hence, before you invest in a hybrid mutual fund, it is essential to know the fund's exposure to know how you will be taxed.
Equity-Oriented Hybrid Fund
Short-Term Capital Gains Tax - When you redeem your investments from equity mutual funds within one year, the short-term capital gains are taxed at a flat rate of 15%, irrespective of your income tax bracket.
Long-Term Capital Gains Tax - If you redeem your investments from equity mutual funds after a holding period of one year or more, you will be subject to long-term capital gains tax. Capital gains of up to ₹1 lakh a year are exempted from tax. If your long-term capital gains exceed this limit, you will have to pay the LTCG rate at the rate of 10%, with no benefit of indexation.
Debt-Oriented Hybrid Fund
Short-Term Capital Gains Tax - When you withdraw your investments from debt mutual funds within a holding period of three years, the gains you receive are called short-term capital gains. These gains are added to your taxable income and taxed at your income tax slab rate.
Long-Term Capital Gains Tax - When you withdraw your investments from debt mutual funds after a holding period of three years, the gains you receive are called long-term capital gains. These gains are taxed at a flat rate of 20% after indexation. Post this, applicable cess and surcharge will also be levied on your tax.
Taxation Of Capital Gains For Investing Through SIP
A Systematic Investment Plan (SIP) is one of the investment modes through which people invest in mutual funds. You choose SIP when you want to invest a fixed amount in a scheme at regular intervals. You can choose to invest ₹5000 every month or ₹10,000 every quarter.
When the due date comes, your amount will be deducted automatically from your bank account and it will be used to purchase units of the mutual fund scheme. If you wish to know how much you need to invest every month via SIP to achieve your goals, please check the SIP Calculator, created by Koshex.
Here's how capital gains are taxed for investing through SIP. For example, you invest in an equity mutual fund through an SIP for one year and you decide to redeem your entire investment after 13 months. In this case, the units purchased first via the SIP are held for the long term (over one year) and you realize long-term capital gains on these units. If the long-term capital gains are less than ₹1 lakh, you will not have to pay any tax.
On the other hand, if you make short-term capital gains on the units purchased via the SIPs from the second month onwards, these gains are taxed at a flat rate of 15% irrespective of your income tax slab. You will have to pay the applicable cess and surcharge on it.
How To Reduce Your Tax Burden?
Paying taxes is never a fun endeavor. There are several ways in which you can reduce the amount of tax you pay on your capital gains. Below are some strategies that can lower your tax burden.
Stay Invested For A Long Period - You can lower your tax liability to a great extent by holding onto your investments for more than 12 months before selling. Since the capital gain tax on long-term capital gains is lower than that of short-term capital gains will help you load in the long run.
Redeem & Reinvest - In a particular year, you made ₹4.9 lakh from your mutual fund investments of ₹4 lakhs. Let's say, you redeem the entire amount and invest it again. The next year, the total corpus will become ₹5.6 lakhs, i.e. gains worth ₹70,000. However, if you would not have redeemed and reinvested, the capital gains would be ₹1.6 lakh, and of this ₹60,000 would be taxable.
This method of redeeming mutual fund investments to reinvest for lowering taxes is called tax harvesting. The important thing that you need to notice here is that the redeemed amount should be reinvested immediately. If the money lies idle in the bank, it will get spent or invested unfavorably.
Tax Loss Harvesting - At the same time, you incurred a capital loss worth ₹1,20,000 for another fund in the same year. Hence, this loss would be adjusted against the taxable capital gains of ₹1,50,000 from the previous fund. Hence, you would have to pay tax at net capital gains of ₹30,000 (1,50,000 - 1,20,000 = 30,000). With this strategy, you can even turn a bad year into a good tax-reducing opportunity and add value to your portfolio.
In The End…
It is a good idea to hold your mutual fund investments for a long period of time to reduce your capital gains tax. Since long-term capital gains tax on mutual funds is lower than short-term capital gains tax, it is advisable to stay invested for a longer period.
We hope the article helped you understand the different capital gains taxes on mutual funds. It is important to know how different types of mutual funds attract taxes so that you can choose one that suits your goals, and risk appetite, among other factors. Before you invest in any mutual fund, understand the tax implication and see if it will suit your needs.
If you wish to learn more about other topics such as Equity Mutual Funds, Debt Mutual Funds, Hybrid Mutual Funds, ELSS funds, and other types of investment instruments, such as Fixed Deposits, Digital Gold, and Smart Deposits, head over to our Blogs section. You can also check out our Calculators, where you can learn more about how much wealth you can accrue in certain years.
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