Mutual funds are one of the most common and tax-efficient tools for investment. The returns that are generated when an investor sells or redeems units of a mutual fund are called capital gains. Capital gains are taxable under the Income Tax Act depending on how long you have invested in the MF.
For instance, suppose a mutual fund unit is bought at ₹1,000 and sold at ₹1,100. Then the profit of ₹100 is your capital gain, however, if it is sold at ₹900, the loss of the ₹100 is called capital loss.
This is applicable for both equity as well as debt funds at different rates. An equity fund is one where at least 65 percent of assets are equities. Otherwise, it will be classified as a debt fund. This is important to know since both equity and debt funds have different tax implications.
Based on the period for which funds are held, two types of capital gain taxes are levied. These are Long term capital gain (LTCG) tax and short-term capital gain (STCG) tax. And the time period for both differs in the case of equity and debt funds.
Let's look at each of these separately
LTCG on Equity
In the case of equity funds, any fund held for over a period of 1 year will come under LTCG. One must note that this is calculated from the date of purchase to the date of sale and not on a financial year basis. The taxation rate for LTCG is 10 percent without indexation. However, gains up to ₹1 lakh are exempt from the LTCG tax. Only if your total capital gain is over ₹1 lakh this tax will be applicable to you.
Indexation is a process where the purchase cost of MFs is adjusted on the basis of inflation. So, the overall purchase cost of MF units will be calculated higher depending on the rise in inflation which then decreases the overall capital gains, and hence the taxes levied will also be reduced.
However, this process is not used while calculating the LTCG tax on equity funds.
LTCG tax was not levied till FY18 when it was reintroduced in the Budget proposal.
STCG tax on Equity Funds
When an investor sells funds within 12 months from the date of purchase, they will be liable for STCG tax.
The tax rate for STCG is 15 percent.
LTCG on Debt Funds
For debt funds, the time period of LTCG is three years. Any debt fund unit sold after 3 years from its date of purchase will be taxed at 20 percent with indexation. This means that inflation will be taken into account while calculating capital gains.
Why indexation? Well, it will substantially help you in reducing the overall tax levied in case of long-term capital gains.
STCG on Debt Funds
Debt funds that are held for less than three years will come under STCG. The STCG is taxed based on the income tax slab of the investor. It could be 10 percent, 20 percent, or 30 percent depending on the IT bracket one belongs to.