The key objective behind investing is to generate wealth in the form of interest, dividends, or capital gains. This income on mutual fund investments attracts income tax. Several investors resist themselves from investing in mutual funds for the very same reason. If you want a better clarity of mutual fund taxation, read on to understand how your capital gains can have a impact on your tax outgo.

The income tax paid by you is largely dependent on the duration for which you invest in mutual funds. This period is referred to as the holding period of a mutual fund.

Types of holding period

Different types of investments have varying criteria for what constitutes a short-term horizon and a long-term horizon.

  1. Long-term holding period – Equity investments held for a duration of 12 months or more considered as long-term. On the other hand, debt funds having a holding period of three years or more are considered as long term.
  2. Short-term holding period – In case of equity funds, investments held for less than 12 months are considered as short-term. Equity investments held for less than 12 months are regarded as short-term. Debt funds are considered short-term if the investment is held for less than three years.

Balanced funds or hybrid funds are a type of mutual funds that invest in both debt and equity instruments. Hybrid funds, with equity exposure of 65% or more are taxed like equity mutual funds. If the equity exposure is less than 65%, then they are treated like debt mutual funds.

Taxation on mutual funds

Here’s how two popular investment options are taxed basis their holding period

  1. Equity mutual funds – Short term capital gains tax (STGC) earned on equity mutual funds are taxed at the rate of 15% plus cess and surcharge. Long term capital gains tax (LTCG) on equity investments are taxed at 10% plus cess and surcharge for capital gains over and above Rs 1 lac. Long term capital gains on equity funds of up to Rs 1 lac is free of any tax implications.
  2. Debt mutual funds – Short-term capital gains on equity mutual funds are taxed basis the income tax slab an investor belongs to. Long-term capital gains on debt mutual funds are taxable at the rate of 20% plus cess and surcharge with the benefit of indexation.

Here’s a table that summarises the taxation on mutual funds:

Type of mutual fund Short-term capital gains (STCG) Long-term capital gains (LTCG)
Equity mutual funds 15% + cess + surcharge 10% + cess + surcharge. Gains up to Rs 1 lac are exempt from tax
Debt funds Taxed at the investor’s income tax slab rate 20% with indexation* benefit+ cess + surcharge

As an investor, it is important to factor in the tax implication on your mutual fund investments as taxes have the potential to take away a huge junk of your earnings. So, before you decide where to invest money, make sure to analyse the tax implications. Unlike lumpsum investment, SIP investment can be a bit tricky to analyse your tax outgo. Happy investing!

*In mutual funds indexation means adjustment of capital gains (LTCG) earned on non-equity investments to Cost Inflation Index (CII) to reduce tax.