Holding period and taxation:
The period over which investors stay invested in a mutual fund scheme is known as the holding period. The holding period plays a critical factor in determining the tax implications of an investment. There are basically two types of holding periods. Your capital gains from mutual funds are taxed differently as per the holding period.
- Short term holding period:
Long term holding period:
- Equity MFs: In the case of equity funds, a holding period of over one year (>1 year) is known as long-term.
- Debt MFs: In the case of debt funds, a holding period of over 3 years (>3 years) is known as the long-term.
Capital Gains & taxation:
When you make a profit on a sale of mutual funds, it is called capital gains. For calculating the capital gains tax, you first need to classify it as short-term capital gains (STCG) or long-term capital gains (LTCG). It depends on the holding period. As can be seen from above, in case of equity funds, holdings above 1 year will attract LTCG, while in case of debt funds, holdings above 3 years will be LTCG. Let us look at how capital gains are taxed for equity mutual funds.
Taxing Equity MFs
- STCG - When Equity MFs with growth option are sold or redeemed within a one-year period, one is liable to pay a STCG tax of 15% on returns.
- LTCG – This is where it gets a little bit complicated. As per the Budget 2018 speech, a new LTCG tax on equity oriented mutual funds & stocks will be applicable from 1st April. Long-term capital gains exceeding Rs1 lakh arising from redemption of mutual fund units or equities on or after April 01, 2018, will be taxed at 10 % + cess (or at 10.4%). Let us understand this with an example.
a. A person who sells shares after April 1, 2018 shall be required to pay LTCG at the rate of 10% on gains of more than Rs1 lakh. For such shares, the notional cost of acquisition will be the price on January 31, 2018.
b. A person who sells shares after April 01, 2018, at a loss, the cost of acquisition for such shares would be the price on the actual date of acquisition and not the notional cost on January 31, 2018. This becomes a little tricky when you invest via SIP and redeem as lumpsum.
In the case of equity mutual funds, this taxation can be explained as follows:
For any redemption where there are multiple dates of investment, the rule of “first-in-first-out” must be followed. This means it is assumed that what was bought first will be sold first. Let's look an example. Assuming, there's a monthly SIP of Rs10,000 and units are allotted as per the table below. For better understanding only three months considered.
|Purchase date||Units||NAV(Rs)||SIP (Rs)|
Total units accumulated equals to 588 (Fractional units ignored) and the NAV on 01-Oct 2018 is assumed to be 75. Now, say 300 units are to be redeemed on 01-Oct 2018, then, 200 units of 01-Oct-2017 and 100 units of 1st Nov will be considered. As 200 units have completed 12 months, they will be subject to LTCG while the gains made on the balance 100 units will be short-term in nature, as they have been held for 11 months. But, some of the gains in one's SIP could have been accrued till January 31, 2018, which has been grandfathered (exempted) under the income tax rules, and therefore, will have to be accounted for accordingly.
There is a way you can circumvent paying the 10% LTCG tax. As long as your gains remain below Rs1 lakh, you are not liable to pay the tax. When the profit from your invested capital surpasses Rs1 lakh, all you have to do is redeem gains above Rs1 lakh and re-invest the same after a period of time, preferably when the markets have fallen and valuations have cooled off. In this way, you can make profits as well as avoid paying LTCG on gains.
Taxing Debt MFs
STCG –In case of debt funds, the STCG (less than 3 years) will be taxed at your peak income tax rate applicable (10% or 20% or 30%).
LTCG- If you sell your investments in debt funds after 3 years, the gains are treated as capital gains and are subject to LTCG of 20% with indexation benefit. However, indexation allows for inflating the purchasing price of an asset taking into account the cost inflation index (CII), in effect reducing the taxable corpus. Inflation erodes the value of the asset over time. For e.g.: the actual value of Rs3,000 over 5 years, assuming an annual rate of inflation of 5%, would be Rs2,321. Hence, it must be taken into account when computing tax on the difference between the buy and sell cost. Indexation takes inflation into account during the holding period of the asset and raises its acquisition price accordingly. Let’s understand with an example.
Suppose you have invested Rs1 lakh in debt mutual fund scheme in January 2015 and sold it for Rs1.4 lakh in June 2017. Since the investment was held for more than three years, it qualifies for long term capital gains taxes with indexation benefit. To calculate the indexed cost, you would need CII of two financial years i.e. the financial year in which the units are purchased (2014-2015) and the financial year in which it was sold (2017-18). CII is decided on a financial year basis and is released by the government annually.
The mathematical formula to attain inflation adjusted cost price is as follows:
Indexed cost= (CII for yr of sale/CII for yr of purchase) * (Cost of purchase)
Indexed cost = (272/240) * 1,00,000 =Rs1,13,333
So effectively, your taxable long-term gains after indexation= Rs26,667. This is comparatively lesser than the actual gain of Rs40,000.
ELSS funds and section 80C
Equity Linked Saving Schemes (ELSS) is a type of diversified equity mutual fund where most of the corpus is invested in equity and equity-related products. ELSS funds have a lock-in period of three years. They are financial products that aid tax saving. According to the Income Tax Act, a person can invest up to Rs1.5 lakh/annum in ELSS under section 80C to save tax. They have the lowest lock-in period (i.e. 3 years) among all the investment instruments available under section 80C. Even though ELSS has a lock-in period of 3 years, and attracts LTCG of 10%, if profits exceed Rs1 lakh, it is still a very viable option for creating wealth over the long term. ELSS funds can be structured in the form of SIPs by allocating a pre-determined amount to an ELSS every month. Such funds can also generate high returns due to their equity component.