Mutual Funds are tax efficient investments

Everybody knows that bank deposits are attractive investments now with returns in the range of 9-10%. But are you aware of the tax implication on the interest income? The interest earned on a bank deposit is added to your income and are taxable. Mutual fundsare very good for long term wealth creation. Another advantage of investing through mutual funds is the attractive tax treatment. If you are investing 1 lakh in equity mutual fund and getting 1, 21,000 after 2 years, you need not pay any tax on the 21000 gains. But if it was invested in a bank deposit, the interest of 21,000 is taxable as per your tax slab.

Let us discuss the mutual fund taxation.

Equity Mutual Funds:

From taxation angle, Equity mutual funds are those funds where equity holding is more than 65% of the total portfolio. Even most of the balanced funds will fall under Equity Funds, because they maintain more than 65% in equity.

Income from a mutual fund can be divided into 2 parts

1. Increase in the value of investment (capital Gain)
2. Dividends

Let us see how tax is calculated on the above 2 income from Equity Mutual funds.

Capital Gain is the increase in the value of your investment. It is divided into short term and long term for taxation purpose.

Short term capital Gain arises if investment is hold for less than 1 year or in simple words sold before completion of 1 year (365 days).

Short Term Capital gain on Equity Mutual Funds – if you sell equity mutual fund before completion of 1 year you need to pay tax of 15% on capital gains. (15.45% with 3% cess)

Long Term Capital Gain arises if investment is sold after 1 year. Long term capital gain on equity mutual funds are tax free. You need not pay any tax on the gain. This is the biggest advantage for long term investors.

The dividend income from Equity mutual funds are also tax free. There is no dividend distribution tax also in case of equity mutual funds.

So, you need to pay tax of 15% on the gains, only if you sell the units within 365 days from purchase. Otherwise all income received is tax free in the case of equity mutual funds.

Debt Mutual Funds:

All other funds which will not qualify as equity fund, including Fund of Fund and international Fund will be treated as debt funds for taxation. Definition of Short Term and Long Term is same as mentioned in equity funds.

Short Term Capital gain on Debt Mutual Funds – any short term capital gain that arises due to selling of debt fund before 1 year will be added to investor’s income and taxed according to tax slab of the individual.

Long Term Capital gain on Debt Mutual Funds – The tax will be calculated as follows.

• Without Indexation – 10% tax on capital gains
• With Indexation – 20% tax on capital gains

Indexation provides for adjusting the returns to offset the effect of inflation to some extent. In order to determine the capital gains after accounting for inflation, the indexed cost of acquisition is subtracted from the sale consideration. You need to pay tax only on this difference. This will really reduce your tax burden. We can understand the effect of indexation with an example.

Suppose you had invested Rs 10,000 in a debt fund in financial year 2009-10 and sold in financial year 2010-11 for Rs.11, 000. The ratio of the inflation index at the time of sale (2010-11) to its value at the time of purchase (2009-10) works out to 1.125 (711/632). The indexed cost of acquisition will work out to Rs 11,250. So, there is a capital loss of Rs.250/- in this case and there is no need to pay any tax on the maturity amount of Rs.11000/-.Only if there is a gain above the indexed cost of Rs.11250, you have to pay tax at 20% on such gains. This makes debt mutual funds attractive over other debt instruments.

Dividend income from Debt Mutual Funds are tax free in your hand. But there is dividend distribution tax paid by mutual funds to income tax department. The rate of tax depended on the type of debt funds.

Dividend Distribution Tax on Liquid/Money Market Schemes

Liquid/Money Market Schemes are Debt funds which invest in money market instruments or in securities that have maturity of less than 90 days.

27.038% tax (25% Tax + 5% Surcharge + 3% Cess) will be deducted from the dividends in this case.

Dividend Distribution Tax on Debt Funds other than Liquid/Money Market Schemes

13.519% tax (12.5% Tax + 5% Surcharge + 3% Cess) will be deducted from the dividends in this case.

So from tax point of view, it makes sense to plan your investments through mutual funds. You can decide a combination of equity funds and debt funds, as per your risk profile and investment duration. This will reduce your tax burden, compared to other investments.