When you invest in mutual funds, you
consider various points like expected returns, goals, time horizon, etc. but
unfortunately most investors do not take into consideration tax implication of
their mutual funds.
It is important to do so since they affect the
overall returns and other decisions like the structure of your portfolio and
the timing of your exit.
How are mutual
funds taxed?
Mutual funds are taxed based on the asset
classes they invest in.
There is one set of rules for equity mutual
funds and another for debt mutual funds.
For the purpose of taxation, international
mutual funds are considered as debt mutual funds.
Equity mutual funds
An equity mutual fund is a fund that
invests primarily in shares of companies.
Since equity mutual funds carry the most
risk among all mutual funds, they also have the potential to generate the
highest returns.
For a fund to qualify as an equity mutual
fund, it needs to invest 65% of its corpus in equities at all times.
Only tax saving mutual funds, also known as
elss funds need to invest 80% of its corpus in equities at all times as opposed
to 65% for other equity mutual funds.
LTCG
Long term capital gains tax better known as
LTCG is applied on equity mutual funds when the gains from equity mutual funds
held for more than a year are more than 1 lakh.
The LTCG rate is 10%.
Capital gains up to 1 lakh are exempt for
taxes.
There is no indexation benefit when
calculating LTCG.
STCG
Short term capital gains tax better known
as STCG is applied on gains from equity mutual funds which are held for 12
months or less.
The STCG rate is 15%.
There is no ceiling benefit in STCG like
the 1 lakh ceiling in LTCG.
STCG is charged on from Re 1.
Debt mutual funds
Debt mutual funds invest in government
securities, debentures, corporate bonds, etc. unlike equity mutual funds which
invests primarily in equity and equity related instruments.
They provide lower returns than equity
mutual funds but more safety.
They are less volatile than equity mutual
funds and are more suited for short term goals.
Additional reading: Click Here to read our complete report on ESG mutual funds
LTCG
For debt mutual funds, long term capital
gains tax is applied on gains from debt mutual funds held for more than 36
months.
The LTCG rate for debt mutual funds is 20%
after indexation.
STCG
For debt mutual funds, short term capital
gains tax is applied on gains from debt mutual funds held for less than 36
months.
Short term capital gains are added to your
income and taxed as per your income tax slab.
Taxes on
International mutual funds
International mutual funds are taxed as debt
mutual funds.
The taxation rules applicable on debt
mutual funds are applicable on international mutual funds too.
It is the same for all international mutual
funds irrespective of the geography.
Meaning a US based international mutual
fund will be taxed in the same manner as a European, emerging markets or Asia
based.
What is
Indexation?
Indexation is a procedure by which the
purchase price of an asset is adjusted according to inflation.
Therefore, indexation increases the
purchase price of an asset.
This reduces the overall gains and in turn
the taxes to be paid as well.
Indexation allows you to adjust the price
with respect to the Cost Inflation Index (CII), indexation takes into account
inflation.
The Cost Inflation Index (CII) is updated
annually by the Government of India.
Understanding Indexation
Let us say that Raj had invested 50,000 on
1st April 2017 in a debt mutual fund.
He redeems the total investment standing at
70000 on 1st June 2020.
The total gain therefore is 20,000.
Since the investment has been held for more
than 3 years, Raj can avail the benefit of indexation.
As previously mentioned, the Cost Inflation
Index (CII) is updated annually by the Government of India.
|
Financial Year |
Cost Inflation Index |
|
2017-18 |
272 |
|
2018-19 |
280 |
|
2019-20 |
289 |
|
2020-21 |
301 |
Source:
Cost Inflation Index released by the Government annually
The cost inflated purchase price will
therefore be:
50000 x
CII of Selling year
CII of Purchase year
50000 x 301 = 55330.88
272
The purchase price now for calculating your
LTCG is now 55330.88 instead of 50000.
This reduces your taxable gains from 20,000
to 14,669.12.
You will now be taxed 20% (LTCG on Debt mutual funds) plus any surcharge/cess
applicable on 14,669.12 instead of 20,000.
|
Selling Price |
Purchase Price with
Indexation |
Purchase Price without
Indexation |
|
70,000 |
55330.88 |
50,000 |
|
Taxable Gains |
14,669.12 |
20,000 |
The very visible and obvious benefit of
Indexation on debt mutual funds is the reduction of your taxable gains but also
having the option of making higher gains compared to other fixed income
instruments.
This is because traditional fixed income
instruments like Fixed Deposits and so on do not have the option of indexation.
The calculations in the above post
have been provided in good faith but should not be judged on their accuracy,
tax laws are liable to changes and for any query regarding tax calculation one
should refer to their tax consultant.
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