Mutual funds have become the go-to investment option for Indians looking to build wealth. But here’s what many first-time investors don’t realise: Your profits from mutual funds aren’t tax-free. When you invest in mutual funds, the government takes a slice of your profits through various taxes. The amount you pay depends on factors like what type of fund you’ve invested in, how long you’ve held your investment, and the nature of your returns.

Understanding mutual fund taxation is crucial for making smart investment decisions that maximise your returns. This guide will walk you through every aspect of mutual fund taxation in India, helping you become a tax-smart investor. Let’s start! 

Types of Income From Mutual Funds

Your mutual fund investments can generate income in two main ways, and each is taxed differently.

Capital Gains: This is the profit you make when you sell your mutual fund units for more than what you paid. It’s like selling a cricket bat you bought for ₹2,000 at ₹3,000, where the ₹1,000 difference is considered your capital gain.

Dividend Income: Some funds distribute a portion of their profits to investors as dividends. Since 2020, these dividends are taxed in your hands as per your income tax slab rates. If you receive dividends worth more than ₹10,000 in a financial year, the fund house will deduct 10% TDS under Section 194K. You can claim this amount as a refund while filing your income tax return in case your actual tax liability is lower. 

Capital Gains Tax on Equity Mutual Funds

Equity funds are those that invest at least 65% of their money in Indian company stocks. The tax you pay on equity mutual funds depends on how long you hold your investment.

Short-Term Capital Gains (STCG)

If you sell your equity fund units within 12 months of buying them, you’ll pay short-term capital gains tax. As per the latest Budget 2024 changes, STCG is now taxed at 20% plus applicable cess. This increased from the earlier rate of 15%.

For example, if you invest ₹10,000 in an equity fund and sell it after 8 months for ₹12,000, your profit of ₹2,000 will be taxed at 20%, meaning you’ll pay ₹400 as tax.

Long-Term Capital Gains (LTCG)

Hold your equity fund units for more than 12 months, and you qualify for long-term capital gains treatment. The current LTCG tax rate is 12.5% on gains exceeding ₹1.25 lakh per financial year. This means the first ₹1.25 lakh of your annual long-term gains is completely tax-free.

Let’s say you make ₹2 lakh in long-term capital gains in a year. You’ll pay 12.5% tax only on ₹75,000 (₹2 lakh minus ₹1.25 lakh exemption), which equals ₹9,375.

Capital Gains Tax on Debt Mutual Funds

Debt funds primarily invest in bonds, government securities, and money market instruments. Their taxation rules are more complex and have changed significantly in recent years.

For Debt Funds Purchased Before April 1, 2023

If you bought debt fund units before April 1, 2023, and hold them for more than 24 months, long-term capital gains are taxed at 12.5% without indexation benefit. Short-term gains (holding period less than 24 months) are taxed as per your income tax slab.

For Debt Funds Purchased After April 1, 2023

All gains from debt funds purchased after April 1, 2023, are taxed as per your income tax slab rates, regardless of the holding period. This means there’s no distinction between short-term and long-term gains for these investments.

Hybrid and International Fund Taxation

Hybrid funds that invest less than 65% in equities are treated like debt funds for tax purposes. International mutual funds and gold funds follow the same taxation rules as before, i.e., they’re taxed as per income tax slabs.

From April 1, 2025, funds where debt instruments comprise more than 65% will be classified as debt funds. For units held more than 24 months, LTCG will be taxed at 12.5%, while short-term gains will be taxed as per income tax slabs.

Tax-Saving Mutual Funds (ELSS)

Equity Linked Savings Schemes (ELSS) offer a double benefit, tax deduction and wealth creation. You can claim a deduction of up to ₹1.5 lakh under Section 80C, potentially saving up to ₹46,800 in taxes annually.

ELSS funds come with a mandatory 3-year lock-in period. Since you can only redeem after 3 years, all gains qualify as long-term capital gains, taxed at 12.5% on amounts exceeding ₹1.25 lakh.

Securities Transaction Tax (STT)

When you buy or sell equity mutual fund units, you pay Securities Transaction Tax. Currently, STT is 0.001% on purchases and 0.01% on redemptions of equity funds. While this seems small, it adds up over time.

TDS on Mutual Fund Dividends

If you receive dividend income exceeding ₹10,000 from any single mutual fund house in a financial year (increased from ₹5,000 effective April 1, 2025), they’ll deduct 10% TDS before paying you. This TDS can be adjusted against your final tax liability when filing returns.

How to Calculate Your Tax Liability

Calculating mutual fund taxes involves several steps. First, you need to determine your purchase price (including any additional costs). Then calculate your sale proceeds. The difference gives you your capital gain or loss.

For SIP investments, each instalment is treated separately based on its individual holding period. You’ll need to calculate gains for each SIP instalment and then aggregate them. Many fund houses provide detailed statements that make these calculations easier.

Tax-Smart Investment Strategies

Here are practical ways to reduce your mutual fund tax burden:

  • Use the Annual Exemption: Plan your redemptions to stay within the ₹1.25 lakh LTCG exemption limit each year.
  • Systematic Withdrawal Plans (SWP): Instead of redeeming all units at once, use SWP to withdraw small amounts regularly, spreading your tax liability over multiple years.
  • Tax Loss Harvesting: Sell loss-making investments to offset gains from profitable ones, reducing your overall tax burden.
  • Hold for the Long Term: Equity investments held for more than a year qualify for more favourable LTCG treatment compared to short-term gains.

Common Tax Mistakes to Avoid

Many investors make costly mistakes when dealing with mutual fund taxes. Don’t wait until year-end to plan your taxes and start early in the financial year. You should always report all dividend income and capital gains in your ITR, even small amounts.

Failing to report SIP redemptions is another common error. Each SIP instalment has its own holding period, so track them carefully. Finally, don’t forget to claim TDS credit for any tax deducted on dividends.

Record Keeping and ITR Filing

You should maintain detailed records of all mutual fund transactions, including purchase dates, amounts, and NAVs. Fund houses provide annual tax statements that summarise your taxable income. Dividend income should be reported under “Income from Other Sources,” while capital gains go under the “Capital Gains” section of your ITR.

Conclusion

Understanding mutual fund taxation doesn’t have to be overwhelming. The key is knowing the different tax rates for various fund types and holding periods. Equity funds generally offer more tax-efficient returns for long-term investors, while debt funds are better suited for those in lower tax brackets.

Remember, tax planning should complement your investment strategy, not drive it. Focus on choosing funds that align with your financial goals, and then use tax-smart strategies to optimise your returns. With proper planning, you can significantly reduce your tax burden and accelerate your wealth-building journey.

Start investing early, stay invested for the long term, and use the various exemptions and strategies available to minimise your tax outgo. Your future self will thank you for making these smart financial decisions today. Happy investing! 

FAQs

1. What is the current tax rate on equity mutual fund gains?


Short-term capital gains (holding period less than 12 months) are taxed at 20%, while long-term capital gains are taxed at 12.5% on amounts exceeding ₹1.25 lakh per year.

2. Do I need to pay tax on mutual fund dividends?


Yes, dividend income from mutual funds is taxed as per your income tax slab rates. TDS of 10% is deducted if annual dividend income from a fund house exceeds ₹10,000.

3. How is SIP investment taxed when I redeem?


Each SIP instalment is treated separately based on its individual holding period. You calculate capital gains for each instalment and aggregate them to determine your total tax liability.

4. Can I save tax by investing in ELSS mutual funds?


Yes, ELSS investments qualify for tax deduction up to ₹1.5 lakh under Section 80C. Additionally, gains after the 3-year lock-in period benefit from long-term capital gains treatment.

5. What is the difference between the old and new mutual fund tax rules?

The Budget 2024 increased STCG tax on equity funds from 15% to 20% and LTCG tax from 10% to 12.5%. The annual LTCG exemption limit increased from ₹1 lakh to ₹1.25 lakh.