Mutual Funds Are More Tax-efficient than most other investments…

If you, as an individual investor, have an investment that offers the flexibility of investing in equity, debt, gold and their mix in various combinations, seamless shifting between these assets after investing, and high flexibility in terms of amount, time, tenure and method of investment and withdrawal while also being very tax-friendly and efficient – how would you classify such an investment? An ideal investment!

Well, mutual funds (MFs) can be this and more for your money management. In fact, the tax saving aspect of MFs is not well-known to most people. MFs can be much more tax-efficient while earning good returns for you than most other asset classes.

Mutual funds are primarily of two types – equity and debt funds. Balanced funds, which are a combination of these two types, also get classified as equity or debt for tax purposes depending on whether they have at least 65% equity component or lesser respectively. For MFs, Long Term Capital Gain (LTCG) occurs when a fund is held for at least one year and Short Term Capital Gain (STCG) when period of holding is less than a year.

As far as equity funds are concerned, LTCG is NIL irrespective of amount of gains made while STCG is taxed at a concessional rate of 15%. Thus, if you hold an equity Mutual Funds for just one year, all your gains are fully tax-free irrespective of the amount; and if you decide to sell before one year, the tax is only 15%.

There is a class of MF called Equity Linked Savings Scheme (ELSS), which are equity funds providing tax break under IT Section 80C and have the shortest lock-in of just 3 years amongst all such tax-saving schemes while also giving long-term equity-related tax-free returns. However, there is a likelihood of this tax saving avenue being withdrawn when Direct Tax Code (DTC) gets implemented.

Debt funds follow a slightly different tax-structure. STCG here is added to one’s income and gets taxed at the applicable income tax slab. In case of LTCG however, the tax treatment is interesting. If held for at least one year, debt fund’s LTCG gets the benefit of indexation. Indexation ties your gains to the Cost of Inflation Index (CII) declared by the Government every year. Thus, the paper value of your cost of acquisition is increased as per inflation every year, thus reducing the taxable part of your LTCG. You have the choice of paying 10% tax without indexation or 20% with indexation, as beneficial to you. If you hold a debt fund for a few years and the inflation is reasonably high, you may pay literally no tax and get to keep all the gains.

Gold Mutual funds are also taxed as debt funds and wealth tax does not apply to them while it does to physical gold.

If you hold MFs in their Dividend paying schemes, then for equity MFs, the dividend is non-taxable in your hands. In case of Debt MFs, the dividend is taxed at 25% for money market and liquid funds, while for all other debt schemes, it is taxed at half the rate of 12.5%.

Thus, MFs not only provide you the benefit of having your money managed by professional fund managers but also a very tax-efficient route to investing in a wide range of investment options under a single roof.