Mutual funds are a great tool to build long term wealth. One can benefit from the experience of an expert team to invest their money and grow wealth. Investors understand the benefits of investing in financial assets and are actively allocating more money to such assets when compared to physical assets like real assets and commodities. No wonder the mutual fund industry has been growing at a massive pace. Let us now look at how these instruments are taxed and the changes in taxation after the union budget of 2020.
Mutual fund taxation is determined on the basis on three important parameters which are;
All mutual funds that hold 65% or more in equity instruments are known as equity mutual funds. They include equity oriented hybrid funds which hold 65% or more in equity. The funds that don’t quality under these criteria are taxed as non-equity mutual funds.
Resident individuals are taxed differently when compared to NRIs. The income tax department has a residency calculator to arrive at your residential status.
Equity Investments are considered as short term if held for less than 365 days i.e., 1 year and non-equity investments held for less than 3 years are taxed as short term holdings. The below table illustrates how mutual funds are taxed on the basis of the invested duration;
| Type of Fund | Short Term | Long Term |
| Equity Funds | Held for <12 months | Held for >12 months |
| Equity Oriented Hybrid Funds (>65% in Equity) | Held for <12 months | Held for >12 months |
| All Other Funds | Held for <36 months | Held for >36 months |
The below table summarizes the taxation of resident and NRI for different types of mutual funds held across different time horizons;
| Equity & Equity Oriented Funds | Resident Individual | NRI |
| Short Term Capital Gains (STCG) | 15% | 15% |
| Long Term Capital Gains (LTCG) | 10% above 1 Lakh | 10% above 1 Lakh |
| Non-Equity Mutual Funds | ||
| Short Term Capital Gains (STCG) | Individual Tax Slab | Individual Tax Slab |
| Long Term Capital Gains (LTCG) | 20% with Indexation | Listed 20% With Indexation & unlisted 10% without indexation |
The union budget of 2020-21 abolished dividend distribution tax. Dividends are now taxed at the investor’s applicable tax rate. The budget also mandates Tax Deducted at Source (TDS) @ 10% for resident individuals if the dividend income is more than ₹ 5,000 in a financial year. For NRIs, the TDS is as follows;
| (TDS) for NRIs | STCG | LTCG |
| Equity & Equity Oriented Funds | 15% | 10% |
| Non-Equity Mutual Funds | 30% (Assuming Investor is in the highest tax bracket) | Listed 20% With Indexation & unlisted 10% without indexation |
The biggest change in taxation is with respect to taxation of dividends. Prior to this year, dividends were tax free in the hands of the recipients, but now, they are taxed at the receiver’s end and at his applicable tax rate. For someone in the highest tax bracket, one could end up paying more than 42% taxes on the dividends declared.
Investors with a longer time horizon stand to gain if they move to growth option as it ensures that your wealth grows at a faster rate. The below illustration shows the additional returns generated under the growth option for an investor in the 30% tax bracket;
| Details | Dividend Option | Growth Option |
| Amount Invested @ Year 1 | ₹ 10,00,000 | ₹ 10,00,000 |
| Growth @ 10% | ₹ 1,00,000 | ₹ 1,00,000 |
| Dividend @ 25% | ₹ 25,000 | ₹ – |
| Tax on Dividend @ 30% | ₹ 7,500 | ₹ – |
| Gain @ end of Year 1 | ₹ 92,500 | ₹ 1,00,000 |
| Amount Invested @ Year 2 | ₹ 10,92,500 | ₹ 11,00,000 |
| Growth @ 10% | ₹ 1,09,250 | ₹ 1,10,000 |
| Dividend @ 25% | ₹ 27,313 | ₹ – |
| Tax on Dividend @ 30% | ₹ 8,194 | ₹ – |
| Gain @ end of Year 2 | ₹ 1,01,056 | ₹ 1,10,000 |
| Amount Invested @ Year 3 | ₹ 11,93,556 | ₹ 12,10,000 |
| Growth @ 10% | ₹ 1,19,356 | ₹ 1,21,000 |
| Dividend @ 25% | ₹ 29,839 | ₹ – |
| Tax on Dividend @ 30% | ₹ 8,952 | ₹ – |
| Gain @ end of Year 3 | ₹ 1,10,404 | ₹ 1,21,000 |
| Amount Invested @ Year 4 | ₹ 13,03,960 | ₹ 13,31,000 |
| Growth @ 10% | ₹ 1,30,396 | ₹ 1,33,100 |
| Dividend @ 25% | ₹ 32,599 | ₹ – |
| Tax on Dividend @ 30% | ₹ 9,780 | ₹ – |
| Gain @ end of Year 4 | ₹ 1,20,616 | ₹ 1,33,100 |
| Amount Invested @ Year 4 | ₹ 14,24,577 | ₹ 14,64,100 |
| Growth @ 10% | ₹ 1,42,458 | ₹ 1,46,410 |
| Dividend @ 25% | ₹ 35,614 | ₹ – |
| Tax on Dividend @ 30% | ₹ 10,684 | ₹ – |
| Gain @ end of Year 4 | ₹ 1,31,773 | ₹ 1,46,410 |
| Market Value @ end of Year 5 | ₹ 15,56,350 | ₹ 16,10,510 |
| Additional Return | ₹ 54,160 |
The above illustration makes it very clear that the growth option is best suited to grow wealth in the long run because of its tax efficiency.
The income tax department rewards you with preferential tax treatment if you stay invested for longer time horizons with lower tax rate for equity investments above one year and indexation benefits for debt investments held for more than 3 years. It should also be noted that long term gains up to ₹ 1,00,000 are exempt from taxes each financial year. Connect with a Fee Only Financial Planner to help you with your taxes.