Aditya Birla Sun Life Mutual Fund

Tax implication of Redeeming Equity & Debt Mutual Funds

Jun 01, 2020
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In these uncertain times, many of us may face a cash crunch forcing us to redeem some of our investments to gain liquidity. You may also be looking to redeem some of your mutual fund investments as the milestones of some of your goals are approaching. Either way it is important to understand the tax implications that you can face on the income earned by redeeming mutual funds. This can actually help you decide which investments to redeem by comparing the tax liability that would accrue by redeeming different investments.

Let’s take a look at a step-wise guide for this:

How are redemptions of mutual funds taxed?

Taxation of mutual funds is guided by provisions of the Indian Income-tax Act, 1961. The tax implications depend on two primary factors:

  • Type of mutual fund scheme – Equity oriented fund or Debt oriented fund

  • Whether your redeemed investment in short tenure or a long tenure

Based on these key factors, we have laid out steps to determine taxability:

Step 1 – is the redeemed fund an equity or debt fund?

From a taxation perspective, an equity fund is one in which at least 65% of the investible surplus is invested in equity instruments*. All other mutual funds, whether debt-oriented hybrid funds or pure debt funds qualify as debt funds for taxation purposes.
*Equity shares of domestic companies listed on a recognised stock exchange.

For e.g.: - A large cap fund investing more than 90% in equities would qualify as an equity fund whereas a Corporate Bond Fund with more than 90% invested in debt instruments qualifies as a debt fund.

Step 2 – is your investment short term or long term?

Redeeming investments in long term are subject to a lower rate of tax than if the same investment was redeemed in a short term. Long term or short term from a tax perspective, depends on the period of holding of your investment before redemption i.e.: time lapse between date of purchase of units of mutual fund and date of redemption of the units.

  • For equity funds – short term would be if it is held for less than 12 months and would be long term if it is held for more than 12 months, before redemption.

  • For debt funds – short term would be if it is held for less than 36 months and would be long term if it is held for more than 36 months, before redemption.

Remember that in case of SIPs, period of holding has to be calculated separately for each SIP instalment, even though the entire investment may be redeemed at once.

Step 3 – Calculate gain or loss on redemption

When mutual fund units are redeemed, the excess of the sale value over the cost at which you purchased the investment would be taxed as ‘capital gain’. In case the sale value is lower than the cost, the shortfall would qualify as ‘capital loss’.

In case of debt mutual funds, long-term investments however an additional benefit of indexation is available before calculating the capital gain or loss. The indexed cost is essentially when the original cost is increased to consider the effect of inflation over the years. It is arrived at by multiplying the purchase cost by the ratio of CII of year of sale to year of purchase. CII is Cost Inflation Index which is government published data easily available online.

Step 4 – Application of tax rate

Equity funds are taxed at lower rates as compared to debt funds.

In case of equity funds, short term capital gains are taxed at 15% whereas long term capital gains above INR 1,00,000 in a financial year are taxed @ 10%.

In case of debt funds on the other hand, short term capital gain does not have any beneficial tax provision and is taxed along with the rest of your income at your applicable slab rate whereas long term capital gain is taxed at a rate of 20% with indexation.

The above-mentioned tax rates will be increased by applicable surcharge and cess.

Step 5 – Tax treatment in case of losses

In case redemption of some of your investments result in a capital loss, these can be set off against other capital gains earned from other investments.
Short term capital losses can be set of against both short term and long-term capital gain. However long-term capital losses can only be set off against long term capital gains. This is irrespective of whether the fund is an equity or dividend fund.

Does it matter if you opted for dividend or growth option?

Taxation of gains on redemption remains the same whether your fund is a dividend or a growth option fund. The only difference you may note is that the gains earned on a dividend option fund is likely to be lower than would have been under the growth option as part of the gains have already been distributed as dividend from time to time

As can be seen, equity investments, specifically long-term investments are taxed at lower rates. This is akin to general investing philosophy where equity invested is expected to be more beneficial over the long term.
From a compounding and growth perspective as well as from the perspective of being subject to lower tax rates, long term equity investing can be more suitable for planning your long term goals!

Tax rates/info. mentioned in this document is only intended to provide general information and the same is neither designed nor intended to be a substitute for professional tax advice. Tax implications will depend on nature of transactions, tax status of the investor and tax laws in force at the relevant point in time. Therefore, users are advised that before making any decision or taking any action that might affect their finances or business, they should take professional advice.

Source: http://empower.abslmf.com/files/pdf/Tax-Reckoner.pdf

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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