With tax season upon us, it’s the perfect time to understand how your mutual fund investments are taxed. Whether you’re investing through SIPs or lump sums, knowing the tax rules can help you avoid surprises and plan more efficiently. From capital gains to dividend taxes, being informed will ensure you optimize your returns and remain compliant with current tax regulations.

– Key Factors That Determine Taxation on Mutual Funds

The tax you pay on mutual fund investments depends on several important factors. Understanding these can help you make more informed and tax-efficient investment decisions:

• Type of Fund: The tax rules vary depending on the category of mutual fund—such as equity funds, debt funds, or hybrid funds. Each type is taxed differently under Indian tax laws.

• Dividends: When mutual fund companies share a portion of their profits with investors, it’s called a dividend. These payouts are added to your income and taxed accordingly.

• Capital Gains: If you sell your mutual fund units at a price higher than what you originally paid, the profit is called capital gains. This gain is subject to taxation.

• Holding Period: This refers to the length of time you hold your mutual fund units before selling them. The duration affects how your capital gains are taxed. Generally, the longer you stay invested, the lower the tax rate you pay. Short-term holdings are taxed at higher rates compared to long-term investments.

– How Do Mutual Funds Generate Returns for Investors?

Investors earn returns from mutual funds in two primary ways: dividends and capital gains.

• Dividends are a share of the profits distributed by mutual fund companies when they have excess earnings. If a fund generates surplus income, it may choose to share a portion with its investors in the form of dividends. The amount each investor receives depends on the number of units they hold.

• Capital gains occur when the value of your mutual fund units increases over time. If you sell your units at a price higher than the purchase cost, the profit you make is considered a capital gain. This gain reflects the growth in the fund’s value due to appreciation in its underlying investments.

 – Taxation of Dividends from Mutual Funds

Following the changes introduced in the Union Budget 2020, dividends paid by mutual fund schemes are now taxed in the traditional or “classical” method. This means that any dividends you receive from your mutual fund investments are treated as part of your total income and are taxed according to your individual income tax slab.

Earlier, dividends were exempt from tax for investors because the mutual fund houses or companies paid a Dividend Distribution Tax (DDT) before distributing the dividend. However, this system has been discontinued, shifting the tax responsibility directly to investors.

– Tax Rates for Short-Term and Long-Term Capital Gains

The taxation of mutual fund returns is primarily based on how long you hold your investment. However, recent changes have impacted the way debt mutual funds are taxed.

From 1st April 2023 onwards, any mutual fund that invests less than 35% of its portfolio in equity shares of Indian companies will be treated as a short-term asset, regardless of how long you hold it.

This means even if you keep the investment for several years, the gains will be taxed as short-term capital gains, which are added to your income and taxed as per your income slab.

Refer to the table below for a clearer understanding of the applicable tax rates.

Note: There is an exemption of Rs.1.25 lacs on Long-Term Capital Gains on the transfer of equity shares or equity-oriented units. 

– Taxation of Capital Gains on SIP Investments

Systematic Investment Plans (SIPs) allow investors to invest small amounts regularly in mutual fund schemes. You can choose how often you invest—weekly, monthly, quarterly, half-yearly, or annually—based on your convenience.

With each SIP instalment, you purchase a set number of mutual fund units. When you redeem your investment, the units are sold using the first-in-first-out (FIFO) method. This means the units bought first are the ones considered to be sold first.

For example, if you invest in an equity mutual fund through SIPs for 12 months and then redeem the entire amount after 13 months:

• The units bought in the earlier SIPs (over one year ago) will qualify for long-term capital gains (LTCG). If your LTCG is within ₹1.25 lakh, no tax is payable.

• However, the units bought in the later SIPs (less than one year ago) will attract short-term capital gains (STCG) tax. These are taxed at a flat rate of 20%, regardless of your income bracket, along with applicable surcharge and cess.

So, in SIPs, each instalment holding period is calculated separately, and tax is applied accordingly.

Illustration:

**Assuming that Rs.1.25 lac exemption limit for LTCG has been utilized.

Conclusion:

Understanding the taxation of mutual funds is essential to make informed investment decisions—especially during tax season. Whether your earnings come from dividends or capital gains, each has specific tax implications based on the type of fund, your holding period, and your income tax slab. Recent changes, such as the reclassification of certain debt funds and the taxation of dividends in the investor’s hands, make it even more important to stay updated. By being aware of how SIPs are taxed and how your returns are categorized, you can better manage your investments and reduce your overall tax burden. Ultimately, a well-informed investor is better equipped to maximize post-tax returns and align financial planning with long-term goals.

To understand more on the topic as well as to start investments please feel free to contact us:

Phone: +91-9324609115

E-mail: team@richvikwealth.in

The article is authored by Ms. Ritika Sharma from Team RichVik.