The implication of taxation in a mutual fund is very critical and is often misunderstood. In this article I will try to decode the taxation aspect on mutual funds for the investors.
Short term capital gains tax
Debt funds Any profit or loss made in a debt fund where the period of holding is less than 365 days, is classified as short term and these are taxed as per the income tax slab of the individual based on his total income.
Equity funds are taxed at 15 per cent irrespective of the tax slab.
Long term capital gains tax
Any profit or loss made on financial investment where the period of holding is more than 365 days, is classified as long term.
Equity funds Long term capital gains are exempt from tax.
Debt funds 10 per cent without Indexation or 20 per cent with Indexation whichever is LESS plus education cess 3 per cent.
Indexation means adjusting the price of an asset for inflation i.e. the cost price of an asset is adjusted so that any increase in price of the asset due to inflation is factored in. Inflation is measured every financial year and the value is known in the Cost Inflation Index (CII). Through indexation, one can bring the cost of investment in the debt fund to the current value, after factoring the rise in price (inflation). Below mentioned is an example of how indexation is applied on debt funds:
Cost Inflation Index (CII)
FY11-12 = 785; FY12-13 = 852
Investment amount = Rs 50,000; Return = 10 per cent p.a.; Return on Investment plus initial investment= Rs 55,000;
Cost of Investment = Investment value X CII (current year/ base year)
Cost of Investment = 50,000 X 852/785 = 54,268
Hence Capital Gains = 55,000 - 54,268 = 732
Tax (With Indexation) = 732 X 20.60 per cent = Rs 151
Or
Tax (Without Indexation) = (55,000 - 50,000) = 5000 X 10.30 per cent = Rs 515 (Whichever is less)
Therefore, the tax to pay will be Rs 151. The effective tax rate in this example will be 3 per cent (151/5000).
Dividend distribution tax
Dividend income is tax free in the hand of investors. However, the mutual fund company has to pay a dividend distribution tax (DDT) before distributing this income to its investors. Equity funds are not subject to dividend distribution tax. However, debt funds are subject to the following dividend distribution tax rate:
Debt fund Taxes applicable
Dividend payout/Dividend re-investment option - 28.3 per cent - Liquid funds
13.52 per cent - Debt funds
Short term decision
Equity funds should not be selected in case your investment horizon is short. You may evaluate between a liquid fund or debt fund. For those who opt for the growth option, short term capital gains i.e. capital gains earned out of the investments sold within 12 months from the date of investment, are taxed at one's applicable rate of taxation. However if you opt for dividend payout/reinvestment option, Dividend distribution tax (DDT) on liquid funds stands is charged at 27.03 per cent, whereas DDT on ultra-short term bond funds stands at 13.52 per cent for individual investors. Therefore, mutual funds especially debt fund should offer better post-tax returns.
Long term decision
In case your time horizon is long, you may opt for equity oriented schemes along with a combination of debt schemes. Equity fund investment will not attract any tax if you hold your investment more than 365 days. In case of a debt fund you will be taxed lower of the two - 10 per cent without indexation or 20 per cent with indexation.
(This article is contributed by Ankur Kapur, CFA (CFA Institute, USA). Ankur is a Director- Financial planning with Finqa, a fee based advisory company offering personalized financial plans to individuals and is a registered investment adviser with Securities and Exchange Board of India (SEBI))
For more details -http://finqa.in/
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