If you have a long term investment horizon, carry some risk appetite, and are willing to invest in market linked schemes that offer varying returns then your financial advisor is bound to recommend mutual funds as a tool for wealth creation.
Mutual funds may not offer guaranteed returns, but they have out-performed every other conventional scheme in the past and have become a favorite option of all young as well as seasoned investors. People prefer investing in mutual funds like equity funds instead of investing directly in the stock market. The primary reason is diversification. In stocks, there is concentration risk and sometimes to buy a single stock an investor has to shell out thousands of rupees. But through mutual funds, investors can own a portfolio of such stocks through a single investment and have held small percentages in various such expensive stocks. This also mitigates the investment risk and allows an investor to earn more in the long run.
But how exactly do mutual funds generate returns?
There are two ways in which mutual fund investors can earn dividends – capital gains and dividends. Capital gains are the total returns that the individual gets after selling his or her mutual fund units. However, the selling price of these units must be more than the purchase price for the investor to earn capital gains. The second way in which a mutual fund investor earns is through dividends. Whenever the company makes a profit and is left with additional surplus capital, they distribute it to investors in the form of dividends.
What are the tax implications on mutual fund capital gains and dividends?
Every year when the government releases the Union Budget, this might bring in changes on the tax implications for returns earned from mutual fund investments. We are going to discuss the current tax implications on mutual funds based on Union Budget passed by the government in the year 2020.
Tax on dividends: Earlier dividends were tax free and hence investors were enjoying tax-free dividends. However, as per the new tax implications, any capital gains exceeding Rs 10 lakhs in one fiscal year are eligible for a 10 percent tax deduction.
Tax on capital gains: When it comes to taxation on mutual fund capital gains, there are two types of taxes – short term capital gains (STCG) tax and long term capital gains (LTCG) tax. Before discussing the percentage, let us find out how STCG and LTCG applies to different mutual fund schemes.
For equity funds, investments held for less than one year are applicable for STCG tax and anything after 12 months is applicable for LTCG tax. For debt funds, investments held for less than 36 months are categorized as STCG and anything exceeding that is eligible for LTCG tax.
Tax on equity fund
Any scheme that invests more than 65 percent in the equity market is recognized as an equity fund. Long term capital gains of up to Rs 1 lakh (per fiscal year) are tax-exempt and anything exceeding that attracts LTCG tax of 10 percent.
Tax on debt funds
Mutual funds that predominantly invest in debt related instruments are categorized as debt funds. Short term capital gains are added to the investor’s tax slab and are taxed accordingly. Long-term capital gains are realized after three years are taxed at 20 percent after indexation.
Tax on hybrid funds
Hybrid funds are those mutual funds that invest in both equity and debt assets. When it comes to taxation, equity oriented hybrid funds have the same tax implications as equity funds, and debt oriented hybrid funds have the same tax implications as debt funds.