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How to calculate and save tax on mutual funds?

Posted on 27 Mar 2024
Author: Sayan Sircar

Tags: Tax ; Mutual Funds

11 mins read
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This article is expected to give investors in India a complete guide on the topic of calculation of taxes on mutual funds.

How to calculate and save tax on mutual funds?

Disclaimer: Taxation is a dynamic concept and the content of this article is valid on the date of publication and any subsequent updates. Always consult a professional tax advisor before doing anything that leads to taxes being due.

This article is a part of our detailed article series on the concept of mutual fund taxation in India. Ensure you have read the other parts here:

What is the biggest benefit of holding mutual fund units in demat form?

This articles discusses some benefits and drawbacks of storing your mutual funds in demat mode with one killer feature that makes transmission possible.

What should debt, international and gold mutual fund investors do now that these funds are taxable at slab rate?

This article shows the way forward for investors in debt, gold, hybrid and international funds which have lost indexation benefits on units purchased after 1st April 2023.

Pay lower capital gains taxes for debt mutual funds: understand how indexation works

This article shows you how the concept of indexation lowers the capital gains tax you pay when you sell debt mutual funds.

Which mutual fund has lower tax - international funds at 20 percent vs domestic at 10 percent?

This article settles the question of which type of capital gain calculation is better - debt-type funds taxed at 20% with indexation vs equity-type at 10%.

Pay lower capital gains taxes for equity: understand how grandfathering works

This article explains the concept of equity LTCG grandfathering in detail with multiple case studies and examples.

How to calculate taxes from capital gains and combine them with your other income

This article talks about understanding capital gains tax calculations and computing offsets vs other income.

How is tax calculated on selling shares/MFs and how do to do tax harvesting?

This post discusses the concept of tax calculations and tax harvesting in a simple manner.

📚 Topics covered:

Mutual funds offer both capital gains and income
- Capital Gains Tax Table: Taxation of mutual funds (and stocks)
- Tax on ‘dividend’ (IDCW) income from mutual funds
What is grandfathering in equity mutual funds?
What is Indexation in some debt and other mutual funds?
What is Tax harvesting and why you should do it?
How to switch from regular to direct plans?
What is tax deferment in case of mutual funds and how does it improve returns?
Are you required to pay taxes even if you do not sell your mutual funds?
How to plan taxes with gifting mutual funds?
How to combine mutual funds tax with your other income?

Mutual funds offer both capital gains and income

Capital gains are the profit from selling a capital asset like stocks or mutual funds. Capital gains are of two types depending on the holding period (see the table below):

Long-term capital gain: LTCG
Short-term capital gain: STCG

There is no tax if you do not sell mutual fund units.

Capital Gains Tax Table: Taxation of mutual funds (and stocks)

Type	Portfolio	Short-term capital gains \| Taxation	Long-term capital gains \| Taxation
Shares, Equity MF or equity-oriented Hybrid MF	>65% Indian equity	<365 days \| 15% + cess + surcharge	>= 365 days \| <1 lakh/year is tax free. Gains above 1 lakh are taxed at 10% + cess + surcharge
Balanced Hybrid funds	>40% Indian equity	<3 years \| Taxed at slab rate	>=3 years \| 20% + cess + surcharge on gains post indexation
Debt or Hybrid funds (debt oriented) or Gold or International funds	<35% Indian equity	<3 years \| Taxed at slab rate	>=3 years \| 20% + cess + surcharge on gains post indexation for units purchased before 01-Apr-2023
Debt or Hybrid funds (debt oriented) or Gold or International funds	<35% Indian equity	<3 years \| Taxed at slab rate	>=3 years \| At slab for units purchased after 01-Apr-23

where Capital gains = (Selling price - Buying price) * Units sold

and

buying price post indexation = (Buying price) * (Cost Inflation index today / (Cost Inflation index at the time of purchase)

A surcharge on LTCG on all capital assets, including unlisted shares has been capped at 15% in Budget 2022. This will specifically help startup owners who will now pay lower taxes on selling unlisted shares. Earlier only listed shares had this cap.

Note that for equity shares and equity mutual funds, any capital gains incurred before 31-Jan-2018 is not taxable. This is the so-called ‘grandfathering clause’: Pay lower capital gains taxes for equity: understand how grandfathering works

Tax on ‘dividend’ (IDCW) income from mutual funds

Income Distribution Cum Capital Withdrawal (IDCW) is a recent rename by SEBI for the concept of dividends from mutual funds. The name change happened due to rampant misselling of these funds along with investors thinking that these returns are guaranteed.

Unlike stocks, which pay dividend from the profits of the company, mutual funds offer IDCW plans from the cash held in the fund. There are some caveats here:

IDCW does not guarantee any returns: either on return amount or the frequency. These plans are not suitable for regular income
The fund NAV falls as soon as the dividend is paid out. There is no “extra” return in a fund that offers dividend vs. the same fund that does not i.e. the Growth Plan

NAV = Fund Assets / Outstanding units

Since dividend come from the cash holding, payment of dividend reduces the fund assets and therefore the NAV falls. This dividend is taxable at slab and therefore reduces your returns. You should never choose the IDCW plan under any circumstances. Instead investing in the Growth Plan and selling units as and when needed is the more tax efficient option.

Apart from this, there are a few more nuances on mutual fund taxation that we will discuss. Wherever there are articles linked, please you should refer to those for details.

What is grandfathering in equity mutual funds?

Budget 2018 reintroduced long-term capital gains tax on shares and equity mutual funds. However, profits made upto 31st Jan, 2018 are exempt from tax.

More Details: Pay lower capital gains taxes for equity: understand how grandfathering works

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What is Indexation in some debt and other mutual funds?

For eligible mutual funds (and other assets like houses), indexation benefit increases your purchase price value via a inflation-related factor called CII. For example, if you bought for ₹100, five years back and sold at ₹150, your normal profit is ₹50. But if there was 5% average inflation over this perid, your purchase price, for the purpose of tax calculation is adjusted to 127/100 (where 127 is the CII value for the sale year and 100 is the CII for the purchase year). The tax is now only 150-127 = 23.

More Details: Pay lower capital gains taxes for debt mutual funds: understand how indexation works

What is Tax harvesting and why you should do it?

Tax harvesting is to take advantage of the rule that profits on equity mutual funds are tax-free up to ₹1 lakh/per if held for more than a year. So if you have ₹3 lakhs of profits via selling units purchased more than a year back, there is no tax on the first ₹1 lakh of profit. You can use this tax-planning rule to sell off a bit of your equity mutual funds, book just enough profit to stay below the ₹1 lakh limit, and immediately reinvest in another mutual fund.

More Details: How is tax calculated on selling shares/MFs and how do to do tax harvesting?

How to switch from regular to direct plans?

We have explained before why all direct plans give higher returns than regular plans and how you should switch.

You should keep in mind switching of any kind in mutual funds is a sale followed by a buy transaction irrespective of source and destination funds without exception. Therefore, you will always pay tax when you sell funds to switch to direct.

What is tax deferment in case of mutual funds and how does it improve returns?

Tax deferment for mutual funds means that you pay tax only when you sell. If you are continuously paying tax on your investments, say every year, your total returns is lower. You can think of this using the NPV concept, where more money received earlier, by the tax department, is always better for them. If taxes are not deferred, the income tax department is getting their money earlier which makes it worse for the investor.

This concept should be contrasted with FDs where should you pay tax on yearly interest.

More Details: Understanding tax deferment: how this concept improves your investment returns?

Are you required to pay taxes even if you do not sell your mutual funds?

US-based NRIs, under the PFIC rule, have to pay tax on notional gains, i.e. paper profits, every year if they hold Indian Mutual funds (and ETFs and ULIPs). This tax payment obviously reduces total return from such investments and alternatives exist for US-based NRIs: Wall Street or Dalal Street: which is the best option for US NRIs to invest in Indian stocks based on PFIC rule?

Resident Indians, or non-US Indians do not have to pay tax on notional gains on Indian mutual funds.

More Details: Should US-based NRIs sell off their mutual funds and stocks in India?

How to plan taxes with gifting mutual funds?

Gifting mutual fund units, for example to family members in lower tax brackets might make sense in scenarios like children’s college funding.

More Details: What is the biggest benefit of holding mutual fund units in demat form?

How to combine mutual funds tax with your other income?

Ultimately, whenever you pay taxes, it is paid as a part of your yearly income tax return that has all income and associated taxes. Just because there is capital gains tax from selling a mutual fund, does not mean that the tax will be finally due.

More Details: How to calculate taxes from capital gains and combine them with your other income

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