A mutual fund is an investment pool comprising money collected from multiple investors. The fund corpus is then invested in various financial instruments such as equities, money market products, bonds, and other asset classes. These funds are professionally managed by experienced managers.
The managers allocate the corpus based on the funds’ philosophies. These investments earn returns, which are available for the investors through capital gains or dividend income.
Mutual funds are classified into several types. Here are three common types of mutual funds.
1. Equity funds
These funds invest a large portion of the accumulated corpus in company stocks. The investment objective of equity funds is to achieve long-term capital growth through stock investing. Equity funds are further classified into different types such as large cap, medium cap, small cap, and more. Equity funds are a high-risk high-return type of mutual funds.
2. Debt funds
Such types of funds invest in debt-oriented instruments. These include government securities, corporate bonds, and other fixed-income products. Debt funds have lower risks but deliver lesser returns.
3. Balanced funds
Balanced funds invest the accumulated corpus in different types of equity and debt instruments. Generally, 65 percent of the corpus is invested in equity markets and the balance 35 percent in debt-oriented products. The risks associated with stock market investing are mitigated by the debt instruments included in the fund portfolio. Balanced funds are able to deliver higher returns when compared to debt schemes because equities are included in the portfolio.
Mutual funds deliver an income to investors through capital gains and/or dividends. When there is an income, there would be certain tax implications. There are several ways to minimize the tax liability; however, investors are not able to escape the payment. The tax on mutual funds varies according to the holding period and the type of scheme.
Investors may hold mutual fund schemes for a short term or a long term. The longer the holding period, the greater is the tax efficiency of the investment. The long term for equity and balanced funds is when investors remain invested for 12 months or more. Debt fund investors must hold their investments for at least three years to classify as long-term holdings. When investors exit their equity or balanced fund investments within 12 months, it is considered as short term. Debt fund investors who exit their investments before three years are classified as short-term.
Having understood the different types of mutual funds and holding period, below is how taxes are levied on the income generated through the investments.
1. Taxes on equity funds
Investors who exit their investments after a period of 12 months or more earn long-term capital gains (LTCG). The LTCG earned on equity funds are not liable to any taxes. Some of the top tax-saving mutual funds are equity-linked savings schemes (ELSS). When investors exit their investments before 12 months, they are liable to pay the short-term capital gains (STCG) tax. A flat 15 percent is applicable as the short-term equity fund taxation rate.
2. Taxation on debt funds
Debt funds that are held for a period of three years or more are taxed at a 20 percent long-term capital tax rate post-indexation. Indexation means adjusting the value of the investments from the date of investing until the redemption date. The biggest benefit of indexation is that it reduces the value, which decreases the applicable tax liability. STCG on debt funds are included in the investors’ income and taxed as per their applicable tax slabs.
3. Taxation on balanced funds
Because the majority of the accumulated corpus of balanced funds is invested in equity funds, the tax implications on gains are similar to that applicable to the latter. Investors do not have to pay any LTCG tax when they stay invested for 12 months or more. STCG tax is payable at a flat rate of 15 percent.
Systematic investment plans and taxation
A systematic investment plan (SIP) means that investors invest a predetermined amount on a specific date in certain mutual fund schemes. The investments may be made either fortnightly, monthly, quarterly, or annually. Earnings made through SIP investments are considered as capital gains and taxed as per holding period and type of fund.
Every installment of the SIP is considered as an individual investment. Therefore, the holding period varies for every SIP installment. For example, assume an individual invests INR 5,000 per month in an equity fund for a period of 12 months. At the end of one year, he redeems all the accumulated units. For tax purposes, only the first installment enjoys LTCG and is tax-free. All other installments are considered as short-term and liable to a 15 percent tax rate.
Different types of mutual funds are taxed distinctly. To maximize the return on investments, it is recommended to invest for a longer period. As the holding period increases, the tax benefits become available making the investments more efficient.