Tax benefits of investing in mutual funds

When it comes to investing, a lot of us only factor in the amount of money we can invest and the rate of return that we can get. However, there is one aspect that most new investors fail to take into account, and that is income tax. One can readily invest in a fixed deposit scheme if a return of 7% to 9% is expected. But remember, the returns generated after the maturity date of the Fixed Deposit scheme is fully taxable and hence what one gets after the tax is deducted is about 4-5% returns. This may not be enough to beat the booming rate of inflation.

Therefore, if you’re looking for investment options that are also tax-saving, you need not look any further than mutual funds, specifically Equity Linked Savings Schemes or ELSS. According to Section 80C of the Income Tax Act, a tax deduction of Rs. 1.5 Lakh is applicable for investments. Read on to find out how mutual funds are taxed and how you can save up on taxes via ELSS mutual funds.

How are mutual funds taxed?

Before we delve into the taxation nitty gritties of mutual funds, it is important to know that Income Tax on investments is calculated with one very important factor in mind, and that is the ‘holding period’ of the investment. This is the time for which the investor has invested in the mutual fund. The holding period can either be ‘short term’ or ‘long term’, both of which are considered differently for taxes.

  • For equity based mutual funds, anything less than one year is considered as a short term holding period and a duration of more than one year is considered as a long term holding period.

  • For debt funds, the short term period is anything below and up to 36 months and the long term period is more than 36 months.

  • For hybrid funds that have both equity and debt elements: If the fund contains 65% or more equity share, then it is considered as a full equity fund and tax is applied accordingly. If equity percent is less than 65% then the mutual fund is considered as a debt fund for taxation purposes.

Short term Capital gains tax: This is a type of tax that is applicable for capital gains over a short term, i.e, 12 months for equity funds, 36 months for debt funds.

Long term Capital gains tax: This is the type of tax that is applicable for capital gains over a long term, i.e more than 12 months for equity funds, more than 36 months for debt funds.

What is the actual tax applicable for mutual funds?

Now that we have the bases covered, understanding the actual tax applicable and mutual fund investment tax benefit is relatively easier.

    For mutual funds in equity the taxation will be as follows:

  • Short term holding period (<12 months):

    Tax applicable will be 15%

  • Long term holding period (>12 months):

    Tax applicable will be 10% on any amount gained over Rs. 1 Lakh per annum. If returns are less than Rs. 1 Lakh, then no tax is applicable.

    For debt funds, the taxation is a bit different:

  • Short term holding period (<36 months):

    TTax applicable will be as per Income Tax slab rate of the individual investor.

  • Long term holding period (>36 months):

    TTax applicable will be 20%

Therefore, one can clearly see that any mutual fund investment that is short term will require higher taxes and longer investments will be more tax efficient.

Learning Mutual Fund Tax Benefits

So how does one get tax benefit on mutual fund? Here, a word about ELSS or Equity Linked Savings Scheme is necessary. ELSS is nothing but an equity linked mutual fund scheme and it is taxed exactly in the same way as a regular equity fund. However, an ELSS has a lock-in period of 3 years, which effectively omits short term gains tax (that would have been 15% in a regular mutual fund). So, an ELSS will only require 10% long term capital gains tax and that too only if the annual return exceeds Rs. 1 Lakh.

To conclude, despite the tax applicable on mutual fund returns, there are still plenty of opportunities to get mutual fund tax benefit if one invests smartly. So, if you’re looking to invest money and want a tax saving option, then mutual funds are the way to go.

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