Introduction

Investments in mutual funds have become extremely popular because they help you build wealth over a period of time. Yet, knowledge about mutual fund taxation is necessary to maximize your returns and keep yourself away from any surprise tax outgo. The income tax on mutual funds depends on the type of fund, the duration of the investment, and the relevant tax slabs. Throughout this guide, we will demystify the taxes on mutual fund withdrawals and tax on mutual fund gains, enabling you to make sound investment choices.

How Are Mutual Funds Taxed?

Mutual fund taxation is based on four key factors

      1. Types of Funds

Mutual funds are split into different categories for tax reasons; they are:

• Equity Funds: Invest a minimum of 65% in stocks and charge different rates of tax compared to debt funds.

• Debt Funds: Invest mostly in bonds and fixed-income securities.

• Hybrid Funds: Combination of equity and debt, taxed according to their asset allocation.

  2. Capital Gains

Capital gains occur when you dispose of a mutual fund unit for more than you purchased it for. They are categorized as:

• Short-Term Capital Gains (STCG): If the holding period is less than a specific time (one year for equity, three years for debt funds), short-term tax rates apply.

• Long-Term Capital Gains (LTCG): Gains from investments held beyond the threshold period attract lower tax rates but may still be subject to indexation benefits in the case of debt funds.

  3. Dividend Taxation

A dividend is a portion of profit paid by mutual fund houses to investors. Previously, dividends were tax-exempt for investors since the fund houses used to pay a Dividend Distribution Tax (DDT). But according to the current tax regulations, dividends are now taxed in the investors' hands according to their income tax slab rate.

      4. Holding Period

The term for which you keep your mutual fund investments can have a large impact on taxation. The tax policy is geared to support long-term holdings, with favorable tax rates for long-term capital gains than for short-term capital gains. Therefore, keeping investments for a long time will help minimize the tax burden.

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Taxation of Dividends from Mutual Funds

Earlier, mutual fund dividends were exempted from tax for investors since the company withheld a Dividend Distribution Tax (DDT). However, after the 2020 change in the tax regime, dividends are included in the investor's income and taxed according to his/her applicable slab rate.

Taxation of Capital Gains

Capital gains tax is charged when you redeem mutual fund units at a gain. The tax rate varies according to the holding duration and fund type.Capital Gains Tax on Equity Mutual Funds

Equity funds invest a minimum 65% is invested in listed equity shares of domestic companies

Note: The rates are applicable for the financial year 2025-26

Capital Gains Tax on Debt Mutual Funds

Debt funds invest mostly in fixed-income instruments such as bonds and government securities.

Tax treatment on debt funds

• STCG: Profits on debt funds with a holding period of less than three years are taxed at the investor's corresponding slab rate.

• LTCG: If the investment advisor holds it for over three years, the gains are taxed at 20% with the advantage of indexation, so the tax is lower.

Capital Gains Tax on Hybrid Mutual Funds

Hybrid mutual funds invest in both equity and debt. Their taxability depends on the equity exposure.

• Equity-Oriented Hybrid Funds (Equity exposure >65%): Taxed like equity mutual funds.

• Debt-Oriented Hybrid Funds (Equity exposure <65%): Taxed like debt mutual funds.

Securities Transaction Tax (STT)

• STT is a tax on transactions related to equity-oriented mutual funds. It is only applicable on equity funds and is levied at 0.001% for redemption (sale of units).

• It is collected by the government to control securities transactions. Debt mutual funds are not subject to STT, hence are slightly cheaper in terms of the tax liability on transactions.

Taxation on Systematic Investment Plans (SIP)

Every SIP installment is considered a distinct investment and is taxed separately according to its holding period.

• If SIP units are retained for over one year, they are eligible for Long-Term Capital Gains (LTCG) tax of 10% on gains over ₹1 lakh.

• If SIP units are redeemed within one year, they are subject to Short-Term Capital Gains (STCG) tax of 15%.

Tax Benefits on Mutual Funds

Mutual funds not only give opportunities for building wealth but also tax-saving under certain schemes. The most widely used tax-saving mutual fund scheme is the Equity-Linked Savings Scheme (ELSS).

Equity-Linked Savings Scheme (ELSS)

ELSS schemes are equity-based mutual funds that have tax benefits under Section 80C of the Income Tax Act. Here's how they benefit investors:

• Tax Deduction: Investments in ELSS funds are eligible for a tax deduction of up to ₹1.5 lakh per financial year under Section 80C. This can reduce the taxable income and hence the total tax burden.

• Lock-in Period: ELSS funds have a mandatory lock-in of 3 years, i.e., the invested capital is not allowed to be withdrawn prior to three years from the date of investment. It is the lowest lock-in duration among all tax-saving products under Section 80C (like PPF, which has a 15-year lock-in).

• Growth Potential: Being equity-oriented funds, ELSS funds can provide higher returns than conventional tax-saving instruments such as fixed deposits or PPF.

• Tax on Returns: The returns from ELSS investments kept for more than three years are classified as Long-Term Capital Gains (LTCG) and taxed at 10% on profits above ₹1 lakh in a year.

Therefore, ELSS funds are an excellent option for investors who want to save taxes and create long-term wealth by investing in equities.

How to Reduce Tax on Mutual Fund Gains?

       1. Hold Investments for Longer Durations

• Long-term investments attract lower tax rates, so avoid short-term redemptions to benefit from reduced LTCG rates.

  2. Consider Tax-Efficient Withdrawals

• Withdraw strategically to stay within the lower tax bracket.

  3. Invest in ELSS Funds

• Equity Linked Savings Scheme (ELSS) allows a deduction of ₹1.5 lakh under Section 80C.

• Has a three-year lock-in period.

  4. Opt for Growth Plans

• Growth plans delay taxation until redemption, while dividends are taxed annually.

  5. Use Indexation Benefit for Debt Funds

• Holding debt funds for more than three years provides tax advantages due to indexation.

Conclusion

Knowing income tax on mutual funds is the key to intelligent investing. Whether investing in equity, debt, or hybrid funds, being aware of mutual funds withdrawal taxes and capital gains tax regulations will make you return-optimized. Get familiar with tax regulations, utilize exemptions, and invest intelligently with Motilal Oswal to achieve maximum returns from mutual fund investments.

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FAQs on Mutual Fund Taxation

1. How can I avoid paying high taxes on mutual fund gains?

Invest in ELSS for tax benefits, hold debt funds for more than three years to avail indexation, and use systematic withdrawals to reduce taxable income.

2. Are mutual fund dividends taxed?

Yes, dividends are included in your income and taxed according to your slab rate.

3. Is SIP taxable in mutual funds?

Yes, every SIP installment is treated as an independent investment, and taxation is based on the holding period.

4. Do I need to pay tax if I reinvest my mutual fund gains?

Yes, gains reinvested are still taxable as capital gains.

5. What is the best way to save tax while investing in mutual funds?

Opt for ELSS, hold investments long-term, and use indexation benefits for debt funds.

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