Simplifying the tax implications of MF investments

MUMBAI: Malini Sharma works for a software company. She has lived an independent life all by herself at Mumbai. While her career is going great guns, the usual grouse is about the city life, leaving little time for doing anything else. Not to mention time and wherewithal to track mutual fund investments. While she is usually on top of investing, the tax implication sometimes gets her on the wrong foot. ET gives a tax ready reckoner of mutual fund investments to avoid any confusion.

What are different types of funds ?

Mutual funds can be broadly categorised as equity-oriented and debt-oriented funds. Equity funds, as the name suggests invest a major part of their portfolio (over 65%) in equities. No doubt, these funds have thus been bestowed with similar tax advantages as associated with investments in stock markets. Diversified equity schemes, equity-linked savings schemes (ELSS) and balanced equity schemes are the various categories of equity-oriented mutual funds.

Debt schemes, on the other hand, invest a major part of their portfolio in interest-bearing instruments such as bonds, FDs, government securities, etc., issued by companies, banks and the government. Monthly income plans (MIP), fixed maturity plans (FMP), gilt funds, liquid funds and floating rate funds are the various schemes offered under this category. However, the tax benefits tagged to debt schemes are not as lucrative as those attached to equity-oriented schemes.

Tax Benefits

Income from mutual funds has two facets — dividend income and income derived from redemption or sale of mutual fund units called capital gains. So, what is the tax impact on the mutual fund investor at each of these stages?

a) Dividend Income

It is a very well-known fact now that the dividend income is exempt from tax in the hands of the investor. However, the catch here is that in the case of a debt scheme, the fund is subject to a levy of dividend distribution tax, (DDT) which eventually lowers the dividend payout in the hands of the investor.

Tax Impact

• Debt funds, except for the liquid and money market funds, are subject to DDT @ 12.5%. Add to this surcharge @ 10% and education cess @ 3% and the total tax impact works out to 14.16%.

• Liquid and money market funds are the schemes that invest their money in very short-term debt instruments, ranging from one day to a few weeks and are usually a preferred destination for parking the idle funds for a short period of time. These schemes are now subject to DDT @ 25%. Adding the surcharge and education cess, the total tax impact works out to 28.33%.

• Investors of equity-oriented mutual funds can, however, make merry as their funds are not subject to any DDT.

b) Capital Gains

Whenever an investor sells the mutual fund units at a price higher than the price at which the units were purchased, the differential amount is treated as capital gains and is subject to tax. Capital gains are further classified as long term and short-term gains, depending upon the period for which the investment instruments are held by the investor.

In case of mutual funds, if the units are sold within a period of one year from the date of purchase, the gains arising there from are termed as short-term capital gains, which are subject to tax. But if the units are sold after completion of one year, the gains arising there from are labelled as long-term capital gains, which are either exempt from tax or are marginally taxed, depending upon the nature of the instrument.

Tax Impact

• In case of debt-oriented mutual fund schemes, short-term capital gains are taxed at the normal slab rates applicable to the individual. But long-term capital gains will be taxed at the lower of 10% (without the benefit of indexation) or 20% (with the benefit of indexation). (Indexation is a factor used to adjust the impact of inflation to the cost of acquisition of mutual fund units)

• Equity-oriented schemes provide an added advantage, both in case of short as well as long-term capital gains. While the short-term gains are taxed at the moderate rate of 10%, irrespective of the income tax slab to which the individual belongs, long-term gains are exempt from tax.

• Equity-linked savings schemes have an additional feather tugged to their cap! While the exit is tax free — since these schemes carry a lock-in period of three years, rendering them as long-term investment instruments — the initial investment into these schemes is also eligible for deduction under the Rs 1-lakh threshold of Section 80C.