Mutual fund taxation in India: a plain English guide

Tax decides how much of your return you actually keep. With mutual funds the rules are not complicated, but they differ by the type of scheme and by how long you stayed invested. Here is the whole picture in one place.

Two things decide your tax

1. Whether the scheme is equity oriented. A scheme that keeps at least 65 per cent in Indian equities is treated as equity oriented. Everything else, including most debt funds, gold funds and international funds, is non equity.
2. Your holding period. The line between short term and long term differs for the two groups.

Equity oriented schemes

• Held for 12 months or less: short term capital gains, taxed at 20 per cent.
• Held for more than 12 months: long term capital gains, taxed at 12.5 per cent.
• The first 1.25 lakh of long term gains in a financial year, across all equity investments, is exempt.

Equity arbitrage funds and equity oriented hybrid schemes follow the same treatment, which is why they often appear in tax efficient short term parking plans.

Debt and other non equity schemes

Gains on debt oriented schemes are added to your income and taxed at your slab rate, irrespective of how long you held them. Indexation benefit is no longer available for units bought on or after 1 April 2023. Older units may still follow the earlier rules depending on the purchase date, so check the statement before redeeming.

Hybrid schemes

The treatment follows the equity allocation. A scheme with 65 per cent or more in equity is taxed as equity. A conservative hybrid with mostly debt is taxed as a non equity scheme. Never assume from the fund name; check the scheme document.

Dividends, now called IDCW

Dividend income from mutual funds is added to your total income and taxed at your slab rate. The fund house deducts TDS at 10 per cent when the payout in a financial year crosses 5,000 rupees. For most investors in the higher slabs, the growth option is more tax efficient than an IDCW payout.

What about SIPs and SWPs?

Every SIP instalment is a separate purchase with its own holding period, and redemptions follow first in first out. A systematic withdrawal plan is treated as a series of redemptions, so each withdrawal creates a small capital gain rather than being taxed as income. That is why an SWP is often more tax efficient than an interest paying product for retirees.

Rules that apply to NRIs

Gains follow the same rates, but the fund house deducts TDS at source before paying the redemption proceeds. Relief under a double taxation avoidance agreement can be claimed while filing the return, and the tax residency certificate is usually required. GIFT City based structures can offer a cleaner route for some NRI investors, which is worth discussing case by case.

Switching between schemes, or between regular and direct plans, is a redemption followed by a fresh purchase. It is a taxable event even though no money reached your bank account.

Legitimate ways to pay less tax

1. Use the 1.25 lakh long term exemption every financial year through planned redemption and reinvestment.
2. Harvest losses: book a loss to set it off against gains in the same year. Short term losses can be set against both short and long term gains, and unused losses carry forward for eight years.
3. Hold equity schemes past twelve months before redeeming, where the goal allows.
4. Prefer growth options over IDCW if you are in a higher slab.
5. Use an SWP instead of large one time redemptions during retirement.

The takeaway

Two portfolios can earn the same return and keep very different amounts after tax. Decide the holding period before you invest, redeem with the calendar in mind, and review the gains statement with your advisor before every March rather than after it.