Mutual fund taxation explained: How equity, debt and hybrid schemes are taxed; what investors should factor in

Understanding the tax treatment of financial products is critical for investors looking to optimise post-tax returns, and mutual funds are no exception. While there is no tax liability at the time of investing in or holding mutual fund units, tax comes into play when an investor sells, switches between schemes or redeems units. The tax impact depends on the type of mutual fund and the holding period, according to an ET explainer.No tax while investing or holding unitsThere is no tax incidence when an investor puts money into a mutual fund or continues to hold units. Unlike fixed deposits, tax liability arises only when gains are realised. These gains are treated as capital gains and taxed according to the category of the mutual fund scheme.How equity mutual funds are taxedEquity-oriented mutual fund schemes are those that invest more than 65% of their portfolio in domestic equities. If units of such a fund are held for more than one year, the gains are classified as long-term capital gains (LTCG) and taxed at 12.5%. Long-term capital gains of up to Rs 1.25 lakh in a financial year are exempt from tax.If equity mutual fund units are sold within one year, the gains are treated as short-term capital gains (STCG) and taxed at 20%.Tax treatment of debt mutual fundsIn debt mutual funds, gains are taxed at the investor’s applicable income-tax slab rate, irrespective of how long the investment is held. A debt mutual fund is generally defined as a scheme that invests less than 35% of its portfolio in equity shares of domestic companies.How hybrid mutual funds are taxedHybrid funds invest across asset classes such as equity, debt and gold. Several categories are structured in a way that allows them to qualify for equity taxation, even with relatively lower direct equity exposure.Aggressive hybrid funds typically maintain 65–75% allocation to equity and therefore qualify for equity taxation. Balanced advantage funds and equity savings funds also qualify for equity taxation by keeping the combined equity and arbitrage exposure above 65%.Multi-asset funds, which are required to invest at least 10% each in equity, debt and gold, fall into two broad tax categories. Funds with 65% or more exposure to equity, including arbitrage, qualify for equity taxation. Those with equity exposure between 35% and 65% must be held for more than two years to qualify for long-term capital gains tax of 12.5%.Income plus arbitrage funds, which combine debt investments with arbitrage strategies, attract long-term capital gains tax of 12.5% if held for more than 24 months.Funds linked to precious metals and fund-of-fundsAn equity fund-of-funds (FoF) that invests at least 90% of its total proceeds in equity exchange-traded funds qualifies for long-term capital gains tax of 12.5% if held for more than one year.Other equity-oriented funds, including international funds, attract long-term capital gains tax of 12.5% if held for more than 24 months.In the case of gold ETFs, gains are treated as long-term if the units are sold after 12 months. As per current rules, long-term capital gains on gold ETFs are taxed at a flat rate of 12.5%. For gold and silver fund-of-funds, investors need to hold the investment for 24 months to qualify for long-term capital gains treatment.How dividends from mutual funds are taxedInvestors opting for the IDCW (Income Distribution cum Capital Withdrawal) option should note that dividends are fully taxable. The income is added to the investor’s total income and taxed at the applicable income-tax slab rate, regardless of whether the scheme is equity, debt or hybrid.Using mutual funds to improve tax efficiencyFinancial planners point out that investors can make effective use of the Rs 1.25 lakh annual exemption available on long-term capital gains by planning redemptions during the financial year. For those looking for tax efficiency within fixed-income allocations, arbitrage funds and income plus arbitrage categories may be considered. Hybrid funds can also be used for tax planning, depending on the investor’s risk profile and investment horizon.