For taxation purposes, we can divide the mutual fund into two categories; Equity and Debt. Tax on Mutual Funds such as fund of funds is treated as a debt fund even if the underlying instrument is investing in equity-related instruments. Tax on Debt Mutual funds withdrawal comes with indexation benefits when held for a duration exceeding three years.
Tax on Equity Mutual Funds
Tax on equity mutual funds depend on the duration of the holding period. Capital gains made are subjected to Short Term Capital Gains Tax and Long Term Capital Gains Tax. Long Term capital gains Tax apply if your gains are more than Rs.1 lakh a year. If you choose to redeem your holding within a year then you will be subjected to STCG which is 15% of the gains made. If you choose to redeem after a year, then the tax on your mutual fund is calculated as LTCG which is 10% of the gains made.
In equity funds, there’s a separate category called ELSS funds. A unique feature concerning ELSS investments is that compared to the other open-ended diversified equity mutual funds, investment in ELSS is subject to a compulsory lock-in period of three years. During this period, you will not be able to redeem your investments before the completion of three years from the date of the investment. After the lock-in, if you decide to redeem the investment on the realized gain, as per the current tax rules, LTCG tax applies.
Tax on Debt Funds
Like other Funds, Debt Funds are also subjected to capital gains tax which is Short Term Capital Gains Tax (STCG) & Long-term Capital Gains Tax (LTCG). If the holding period of Debt funds is less than 3 years then STCG is levied and if more than 3 years then LTCG is levied. Presently, the LTCG levied is 20% with indexation and STCG is taxed as per the investor’s tax slab. If the Income Tax Slab of the investor is 20% then the same will be levied on the Debt Funds gains in the case of STCG.
Indexation is a tool which is applicable on long-term investments. It helps an investor to adjust inflation while gaging the returns of the invested amount.
As inflation is gradually rising, what’s worth Rs. 1000 could be worth Rs. 1100 sooner in near future. Thus, inflation impacts the purchasing power of our money. The same amount makes the investor to buy lesser and lesser goods.
So how does indexation help us? To understand that let us first understand what is capital gains. A capital gain is nothing but the increase in the value of an investment over a specific period. If the NAV (Net Asset Value) of a fund was Rs.10 when you invested and is now Rs.15 while you plan to redeem it, that difference of Rs.5 is called capital gains. So we are yielding a capital gain of Rs.5 per unit when we redeem.
In the case of debt funds, we arrive at capital gains after indexing the purchase price of the investment. Indexation lowers the long-term capital gains tax which brings down your taxable income.
Imagine you invested Rs.1,00,000 in May 2015 in a debt fund of your choice. Today you choose to redeem your money. So you have gained Rs. 1,50,000 on your investment. Since your holding period was beyond 3 years you will not need to be required to pay tax on the entire amount of Rs.1.5 lakhs.
You will need to arrive at the indexed cost by using the formula:
ICoA = Original cost of acquisition * (CII of the year of sale/CII of year of purchase)
So the indexed cost will be 1,00,000 (240/301) = Rs.79,734.
So our Capital Gains will now be 1,50,000-79,734 = Rs.70,266.
In the above imaginary example using indexation, taxable income has been reduced to Rs. 70,266.
The benefit of indexation works best when your holding period is longer. For a holding period of 5 years, on average, the long-term capital gains tax on debt funds can come down efficiently. Thus indexation helps us to save tax on Long-Term Capital Gains and increases our earnings.
Remember, indexation is only subjected to Debt Funds & not applicable to Equity Funds.
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