Tax consequences should be one of the most important considerations in investment and financial planning. It is the obligation of every tax payer to disclose the correct taxable income, including income from investments, in their annual income tax returns filing and pay the requisite tax; failure to do so, may attract penalties and interest for late payments. Income or gains from most of your financial investments is taxable with some exceptions which we will discuss later. However, taxation is different for different types for investments. In this blog we will why and how you can plan for your taxes with mutual funds.
Interest Income is taxable as per your income tax rate
Interest income from Bank Fixed Deposits and most Government Small Savings Schemes are taxable as per the income tax rate of the investors. However, there are some exceptions. Interest from deposits Public Provident Fund (PPF) and Employee Provident (EPF) are exempt; however, interest income from EPF contribution in excess of Rs 2.5 lakhs in taxable as per your income tax rate. Investors should also note that incidence of taxation arises as interest accrues. In other words, you will have to pay tax on your Bank FD interest every year, even if the interest is payable to you on maturity.
For example, if you are getting 5% interest on Rs 20 lakh fixed deposit, then the interest amount in the first year i.e. Rs 100,000 will be added to your taxable income. If you are in the 30% tax bracket, then you will have to pay Rs 30,000 income tax + 4% cess on the tax of Rs 30,000, i.e. total tax outgo of Rs 31,200. If your annual income exceeds Rs 1 crore, then you will have to pay 12% surcharge on the income. Please note that you will have to pay tax on your interest income as per your income tax rate, even if the bank deducts TDS at the rate of 10%.
Suggested read: Should you invest in ELSS mutual funds or PPF for tax savings
Capital gains tax in equity mutual funds
One important thing for investors to note is that there is no tax on unrealized gains in mutual funds; incidence of capital gains taxation arises only upon redemption. There are two kinds of capital gains in equity mutual funds. Redemption of equity mutual fund units held for less than 12 months leads to short term capital gains taxation, while redemption of units held for more than 12 months leads to long term capital gains taxation.
Short term capital gains are taxed at 15% (plus applicable surcharge and cess). Long term capital gains of up to Rs 100,000 in a year are tax exempt and taxed at 10% (plus applicable surcharge and cess) thereafter. For example, if your long term capital gain in a year is Rs 200,000, Rs 100,000 will be tax exempt and you will have to pay capital gains tax on Rs 100,000 only at the rate of 10% (plus cess) i.e. tax outgo of Rs 10,400 only. You can see that from a taxation perspective, equity mutual funds are much more tax efficient than traditional fixed income investments.
Capital gains in non-equity mutual funds
Let us first understand what non-equity mutual funds are. Any mutual fund scheme, where average equity allocation is less than 65% are treated as non-equity mutual funds from a taxation standpoint. Non-equity mutual funds include debt funds, conservative hybrid funds, international funds or fund of funds, gold funds etc. There are two kinds of capital gains in debt mutual funds. Redemption of debt mutual fund units held for less than 36 months leads to short term capital gains taxation, while redemption of units held for more than 36 months leads to long term capital gains taxation.
Short term capital gains in non-equity mutual funds are taxed at as per your income tax rate; in this regard, tax treatment of short term capital gains in such funds and interest income from bank FDs is same. Long term capital gains in non-equity funds are taxed at 20% after allowing for indexation benefits. Indexation benefits imply that you are allowed to index the acquisition cost of your units as per Cost Inflation Index (CII) table based on the year of investment and year of redemption. Indexing increases your cost of acquisition and reduces your capital gains amount, thereby reducing your tax obligation. So for investment tenures of over 3 years, non-equity mutual funds have a significant tax advantage over traditional fixed income investments.
SWP is more tax efficient than dividends (IDCW)
Many investors in the past, especially senior citizens used to rely on mutual fund dividends along with bank interest for their regular cash-flows. However, with change in dividend taxation it has now become tax inefficient. Though the Government has abolished Dividend Distribution Tax (DDT), dividends will be taxed as income in your hands; mutual fund dividends or IDCW payments will be added to your income and taxed as per your income tax rate.
Systematic Withdrawal Plan (SWP) is much more tax efficient way of getting regular cash-flows from your mutual fund investments. SWP generates cash-flows for investors by redeeming units of mutual fund scheme at specified intervals. The number of units redeemed to generate cash-flows in an SWP depends on the SWP amount and the scheme Net Asset Values (NAV) on the withdrawal dates. Each SWP payment will attract short term or long term capital gains tax depending on the date of investment and date of SWP payment. For long SWP tenures, you can avail long term capital gains taxation benefits.
Would you like to know more about IDCW? Read this what IDCW is in mutual funds
Save taxes by investing in mutual fund ELSS
You can claim deduction of up to Rs 150,000 from your annual gross taxable income under Section 80C of Income Tax Act 1961 by investing in mutual fund Equity Linked Savings Schemes (ELSS). ELSS enjoys several advantages over other 80C investment options namely:-
- Higher wealth creation potential of equity as an asset class: In the last 10 years (ending 28th February 2022), Nifty 50 TRI gave 13.5% CAGR return. We are showing NIFTY 50 TRI returns as proxy to ELSS fund returns.
- Superior liquidity: ELSS funds have lock-in period of 3 years. This is the shortest lock-in period among all 80C investment options.
- Tax efficiency of returns: Returns of ELSS funds are subject to long term capital gains as applicable for equity funds. We have discussed tax advantage of long term capital gains from equity funds, earlier in this article.
You should remember that the money that remains with you is what is left after paying taxes. Some investments are more tax efficient than others; you should always consider tax consequences of your investments. In this article, we have discussed why mutual funds are among the most tax friendly investment options. You should also know that taxation of various investments can change from time to time. You should always consult with your financial advisor to understand the taxation of your investments and make informed decisions.
You may also like to read Aviod 6 common tax planning mistakes
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.