Mutual funds are financial vehicles for investors looking for a diversified portfolio of securities. Everyone knows the importance of mutual funds for portfolio diversification. However, very few know about the tax benefits of investing in mutual funds. Mutual fund tax benefits can lower your overall tax burden in India. Mutual fund returns, dividends, and capital gains in India are subjected to taxes.  

However, the rules differ for India’s short-term and long-term capital gains. Similarly, there are some additional tax benefits offered to mutual fund investors. As a responsible investor, you must be familiar with the tax benefits. Read on to understand the tax benefits and savings associated with mutual funds. 

Understand How Mutual Funds Work

Before discussing the tax benefits, it is essential to understand mutual funds. Mutual funds are collective investment schemes that help earn returns and re-invest them. Investors can earn compounded profits by doing so. They are investment vehicles that pool money from many investors. 

The collected money is invested in a portfolio consisting of diversified securities. Instead of buying individual assets, you invest in a basket of securities. A mutual fund portfolio can consist of stocks, bonds, and other assets. Many traders prefer mutual funds to benefit from compounding, cost averaging, and portfolio diversification.

The best part about mutual funds is the decreased burden of investment management. An experienced fund manager will look after the securities and make investment decisions. It frees the investor from decision-making and portfolio management. The fund manager will make decisions according to the fund’s investment strategies. 

You must purchase units of a mutual fund to start your investment journey. The value of a single unit will depend on the market value of all securities held within the fund portfolio. SIPs (Systematic Investment Plans) are another method of investing in mutual fund schemes.

Understanding Taxes on Mutual Funds

There are two types of mutual fund returns: capital gains and dividend income. 

• Dividends are payouts made to mutual fund investors. Let us say a mutual fund scheme has invested in company shares. Whenever the company makes a profit, it distributes a part to mutual fund investors. This distribution of profits is known as dividends. 

• Capital gains come into the picture when you sell your mutual fund units for a profit. If you incur a loss while selling mutual fund units, it will be counted as a capital loss. Let us now understand the mutual fund tax benefits on dividends and capital gains.

Taxes on Dividends of Mutual Funds

Before 2020, dividends earned from mutual funds were not taxable in India. However, the Finance Act of 2020 changed the tax rules for dividends earned via mutual funds. As per the new rule, investors are bound to pay DDT (Dividend Distribution Tax). 

The fund houses will deduct it before distributing dividends to investors. You will pay DDT based on your income bracket and tax slab. The AMC (Asset Management Company) must deduce 10% TDS (Tax Deduction at Source) while distributing dividends.

The AMC can claim TDS deducted while filing the income tax return. Also, TDS will not be deducted when the total dividends paid by the distributor are less than Rs 5,000 in a financial year. You can submit Form 15G or Form 15H for a lower or zero TDS deduction on dividends earned from mutual funds.  

Taxes on the capital gains of Mutual Funds

An investment horizon of less than a year in equity and hybrid funds is considered a short-term capital gain. When the holding period is more than a year, it will be regarded as a long-term capital gain. However, the duration might change for other mutual fund types. For short-term capital gains, investors must pay a 15% tax (including a 4% cess). 

On the other hand, the tax for long-term capital gains is 10% (including a 4% cess). Also, long-term capital gains up to Rs 1 lakh are tax-free in India.

Conclusion

Mutual fund tax benefits must be understood thoroughly by investors. You can rely on a share return calculator to know the capital gains and applicable taxes. Besides investing in equity and hybrid funds, investors can also try ELSS (Equity Linked Savings Scheme) for additional tax benefits.