What are the tax implications of investing in mutual funds?
Saturday, Mar 2, 2024
Introduction
You finally took the plunge and read the terms and conditions carefully. Now that you understand the underlying fundamentals of what mutual funds are, you have the confidence to explore this relatively safe investment medium. From the investment rationale, the journey of your capital, which started from you acquiring it, to investing it, is only halfway. The remainder of this is to contemplate how the returns that your capital earns are treated by the finance ministry. Specifically, the Central Board of Direct Taxes (CBDT) is the authority that decides how much tax in mutual funds you need to pay on the returns you earn from your mutual fund investments. They set the rules, and the Income Tax Department makes sure people follow these rules.
If you have window shopped for mutual funds, you must know that there are so many different types among them!
In this article, we will explore the different types of mutual funds that exist, the differences among them, and the taxation regimes for each type set by the Finance Ministry of India based on the latest developments in the domain.
The ABCs of Mutual Funds — Characteristics
While the basic concept of mutual funds is known and appreciated by fund managers across the world, this simple, low risk investment vehicle is suitable for people who want to explore investing. While high risk investment modes are not really suitable for everybody, this is of course due to the inherent complications that exist with respect to the process of value generation and the entanglements to extrinsic uncontrollable parameters. Mutual funds serve as well placed financial assets that can potentially be deemed risk free as expert investment leaders and finance advisors take care of the management processes.
Breaking down the fundamental types of mutual funds.
Essentially, there are three major types of funds.
1.Equity Funds
These funds are also known as stock funds. They primarily target capital appreciation by investing in publicly traded companies. Equity based mutual funds bet on growth. They typically offer high returns but they have the issue of volatility. This makes them relatively riskier among the lot.
The type of companies that the equity mutual fund chooses to invest in leads to further classifications. Depending on the size of the company, they can be categorized into large cap, mid cap, or small cap focused funds. They can also be classified based on investment styles like growth, and value, and even based on geography, whether domestic or international.
Over a long tenure, equity mutual funds find themselves in a sweet spot as they ensure that they capture the growth trajectory of market capitalization as a whole as well as project themselves as a risk free deal due to the vast diversification across sectors and industries.
Debt Funds
Government securities, bonds, and corporate debt are all fixed income securities. These securities are especially safe due to their inherent nature. So, any mutual fund that allocates more than 65% of its investments to fixed income instruments like these falls under the category of debt mutual funds.
Due to their increased association with debt based government backed securities, they do not see rapid fluctuations and volatility but rather follow a stable and linear growth trajectory. This makes debt mutual funds safer while also consistently offering moderate returns.
For investors who are not used to investment terminologies and jargon, fixed-securities seem trustworthy as they are backed by the government. For investors with a conservative mindset, debt mutual funds are great because of their regular income prospects.
If you are wondering if there are any specific further sub classifications, there are. Debt mutual funds can be categorized based on who the issuer is, whether the government or the corporate, as well as on the credit quality and the maturity duration.
Hybrid Funds
By combining a portfolio of mixed equity and debt assets, hybrid mutual funds are purpose driven. The objective of hybrid mutual funds varies and depends fundamentally on investor preferences. If growth at all costs but with some cushion in case of a market downturn, is what the investors are seeking, then aggressive hybrid mutual funds achieve this by investing 65 to 80% in equity and 20 to 35% in debt. Higher exposure to equity means greater growth potential and chances at capital appreciation.
On the contrary, if the hybrid mutual fund is aimed at withstanding the volatility and turbulent nature of the markets, then a conservative approach is realized. That means maintaining a 75 to 90% exposure to debt based instruments and a relatively small portion of 10 to 25% exposure to equity related instruments. High exposure to debt reduces the chances of a downtrend affecting the fund holdings that much and hedges against the negative cycle.
Then there are funds that invest in three or more asset classes, like equities, debt, gold, and commodities. These are the mixed asset allocation funds. By using a dynamic allocation strategy based on the current market phase and status, asset adjustments are made. The funds might shift from 100% equity to 100% debt. Creative hybrid mutual funds with the objective of creating a monthly income plan also exist. They focus on fixed income securities with limited exposure to equity.
The price differentials between the cash and derivatives markets can be exploited and arbitrage funds actively pursue this. Suppose the stock ABC is trading at ₹ 100 in the cash market and its futures contract for one month is priced at ₹ 105. The arbitrage fund buys ABC in the cash market at ₹ 100 and simultaneously sells ABC futures at ₹ 105. When the futures contract matures, the fund delivers the stock at ₹ 100 (cash market price) and pockets the ₹ 5 spread.
The XYZs of Mutual Funds — The Taxation
Upon realizing all the different forms that mutual funds can take, the fundamentals of taxation norms can be understood. Though taxation can be studied separately, the terminologies can be misinterpreted and misunderstood by the common investor. That’s why it's crucial to understand the various types of mutual funds that exist, as each of them might be taxed in a different manner.
In this section, let’s understand the primary aspect of tax in mutual funds.
Taxes on Equity Centric Mutual Funds
Short-Term Capital Gains (STCG):
If you sell equity mutual fund units within 12 months (1 year) of purchase, the gains are termed short-term capital gains. These are added to your other income and taxed at your applicable income tax slab rate. For holding periods of less than 1 year, the tax rate is 15%.
Long-Term Capital Gains (LTCG):
If you sell your units after 12 months, the gains are termed long term capital gains. LTCG on equity funds is taxed at a flat rate of 10% plus applicable cess and surcharges. Although, gains below ₹1 lakh are tax free. The gains exceeding this value are taxed at 10%.
Taxes on Debt Centric Mutual Funds
Short-Term Capital Gains (STCG):
For debt centric mutual funds, the selling period that constitutes the short term is different. Selling the mutual fund units within 36 months will label them as a short term capital gain. The gains will be added to your income and taxed at the slab rate applicable to you.
Long-Term Capital Gains (LTCG):
For the long term, however, they are taxed at 20% after indexation benefits (adjusting for inflation) or 10% without indexation.
Indexation? Why should you care?
It reduces the tax that you’re liable to pay!
Let’s say you bought a debt mutual fund for ₹ 1,00,000 a few years ago.
Now you’re selling it for ₹ 1,50,000. Your gain seems to be ₹ 50,000.
But wait! Indexation steps in and says, “Hey, inflation happened during these years.”
If the Cost Inflation Index (CII) shows that prices went up by, say, 20%, your adjusted purchase price becomes ₹ 1,20,000 (which is the original price * 1.20)
Now your actual gain is only ₹ 30,000 (₹ 1,50,000 - ₹ 1,20,000).
Only the adjusted gain is taxable, not the full ₹ 50,000.
Taxes on Hybrid Mutual Funds
These funds are taxed according to their structure. If they are equity-heavy (> 65%), they are treated as equity funds, and if they are debt heavy, they shall be taxed in the same way debt mutual funds are taxed based on the holding period.
What about Special Funds?
How Real Are Funds That Save Tax?
Yes, they are. Very much so!
Deep Dive into Section 80C — Mechanics of Tax Saving
This section states that, if you make specific investments that are approved under this law, those investments directly result in tax deductions on your taxable income. This also works for certain expenditures that are eligible under it. So, which type of investment are we talking about? There are many! Let’s explore them in this section.
Equity-Linked Saving Scheme (ELSS)
This mutual fund invests primarily in equity related products. But since they fall under the Section 80C paradigm, investors in this fund can claim a tax deduction of up to ₹1,50,000 every year! With the allocation consisting of equities, which make up more than 65% of the fund allocation, these funds are targeted at growth. If you start a monthly systematic investment plan (SIP) in ELSS for the long term, you will ensure a lifetime of tax deductions as you will be saving up to the limit every year.
Although you do not have the option of a premature exit, it’s notable that the lock in period itself is just three years.
Summing Up.
Investing in Mutual Funds seems to have no downsides!
If you find it tough to understand financial investment instruments, investing in mutual funds is the perfect beginning for your journey. While exploring all the unique types of mutual funds that exist, you can watch and learn as your investments start paying off. Staying invested will also enable you to contemplate why certain funds behave in a certain way. Whether you are interested in getting a sense of the adrenaline that comes with staying invested in a small cap majority mutual fund, or feeling a sense of calm when everybody else is highly stressed out because of a market downturn due to the fear of an impending recession, because you have safeguarded your investment by investing in a debt mutual fund, you will understand the underlying mechanisms of the finance world. Instead of you taking the calls, it's watching your kid learn cricket from a member of the Indian cricket team itself!
Greenportfolio is on the verge of entering the mutual fund game via the new mutual fund smallcases. With the experts crafting the perfect plan, you can stay confident about your investment strategy and begin your mutual fund investments journey with this exciting development from Greenportfolio.
By committing your capital to mutual funds, you will enjoy tax deductions while diligently growing your capital. Knowing what funds you want to invest in and the tax implications of them will let you stay confident about your investments.
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