Long-Term Capital Gains Tax on Mutual Funds: A Detailed Overview

The Union Budget for the fiscal year 2024 which was presented in February 2024 proposed substantial modifications in the type of capital gains taxation that affects the taxation of mutual funds. The new rates of the Long Term Capital Gains (LTCG) tax intend to sustain long-term investments while both short-term and long-term capital gains are clear-cut. Now, let’s take a closer look at how LTCG tax works in the case of mutual funds in the financial year 2024-25.

What is Long-Term Capital Gain Tax (LTCG)?

Long Term Capital Gains (LTCG) are defined as the income which is gained from the disposal of an asset that has been owned for a period of more than one year. In the case of mutual funds, these profits are realized when the holder sells units of that mutual fund after having held them for a particular time – known differently for equity mutual funds and debt mutual funds.

The Union Budget of 2024 outlined taxation of LTCG at 12.5% for mutual funds; there is now no scope for indexation adjustment. This was a big alteration from prior tax rates and was designed to provide more liberation for long-time investments.

Mutual Funds and Their Holding Periods

Before explaining how the LTCG tax is applied, one needs to understand the mutual fund classification. Mutual funds in India are primarily divided into two categories, as follows:

Equity-Oriented Mutual Funds: These are majorly invested in stocks or equities. In order to be eligible for LTCG, the units of the equity-oriented mutual funds should be held for more than 12 months. Any profit which is earned from the sale of equity mutual fund units where the holding period is more than 12 months is considered a long-term capital gain and is so taxed.
Debt-Oriented Mutual Funds: These funds are used in buying bonds, government securities, and corporate debenture among others. Compared to equity funds, the holding period for debt-oriented mutual funds to qualify for LTCG is quite more extended. For you to realize LTCG on these funds, you have to hold them for more than 24 months. If they are held for less time, then the gains will be classified under Short Term Capital Gains (STCG).

Capital Gains Tax on Different Types of Mutual Funds

Various categories of mutual funds are taxed in various manners depending on the class to which they belong, as follows:

Equity Funds: In case you sell your equity mutual fund units after 12 month holding period, the long-term capital gains are taxed at 12.5% If the capital gains exceed one lakh rupees in a financial year. Suppose you have sold your equity mutual fund units after 18 months and now you gain Rs. 1.5 lakhs, then you have to pay 12.5% tax on Rs. 50,000 which is a gain over Rs. 1 lakh.
Equity-Oriented Hybrid Funds: These funds invest in both equity and debt securities, but there should be at least 65% of the portfolio in equities. The treatment in tax legislation is also similar to that of ordinary equity mutual funds. For investors, long-term capital gains are charged at 12.5% anytime after 12 months of the holding period for equities.
Debt Funds: If the holding period is more than 3 years, then debt mutual funds are levied a tax at the rate of 20% with indexation. Indexation aids in arriving at an inflation-adjusted price for the purchase thus lowering the tax on the profit earned. For example, if you initially invested Rs. 1 lakh and liquidated it in 3 years for Rs. 1.5 lakh, indexation will let you index the purchase price for inflation and may cut your taxes on gains.
Debt-Oriented Hybrid Funds: These funds hold both equity and debt securities but the majority of the funds are in debt which is more than 60%. The gains that accrue on these funds are taxed after a period of 3 years at 20% with the benefit of indexation.
Unlisted Equity Funds: Under unlisted equity funds the capital gains are taxed at 20% but with an indexation advantage. Unlike the listed equity funds these funds do not have any lock-in period but are however provided with unique tax privileges. If you buy an unlisted equity fund and exit it after 3 years with an appreciation of Rs. 2 lakh, the amount will be taxed at 20% with indexation.

Latest Updates on LTCG Tax in the 2024 Budget

The Union Budget 2024 brought key updates to the LTCG tax framework for mutual funds:

Equity-Oriented Funds: The incidence of long-term capital gains from equity-oriented mutual funds is now 12.5% as against 10% earlier with a provision of Rs. 1 lakh for exemption.
Non-Equity-Oriented Funds: For non-equity mutual funds (like debt funds), long-term capital gains tax rate has been reduced to 12.5% from 20% thus giving better tax treatment for long-term debt fund investors.

These changes are intended to help provide more incentives for investors to buy long-term mutual fund investments – especially for those who wish to take advantage of lower taxation on long-term gains.

Strategies to Reduce LTCG Tax

Here are some strategies to reduce the implied LTCG tax even further:

Threshold Exemption: In equity-oriented mutual fund, only the amount in excess of Rs. 1 lakh in a particular financial year is taxed. Thus, for your gains below this benchmark, you do not have to worry about any LTCG tax. For example, if you attain Rs. 90,000 through capital gains from equity mutual funds, no tax would be payable.
Section 54EC Exemption: If you sell a long-term asset such as mutual funds and make a capital gain then you can invest up to Rs. 50 lakh in specific bonds such as those issued by the National Highways Authority of India or Rural Electrification Corporation within six months to avoid paying tax on the gain.
Tax-Loss Harvesting: This means to sell investments to realize losses that may be used to cancel out gains for tax purposes. In case your equity mutual fund investments are a loss, you can sell them and set off the loss to your capital gains tax liability.

Why Long-Term Investments Are Better

Here are the key reasons why long-term investments are efficient:

Lower Tax Rates: Long-term capital gains bear less tax than short-term capital gains. This makes investors retain the investments for a long that is advisable in investment.
Compounding Benefits: Long-term investments help your returns compound, thus increasing your overall investment value a lot more than short-term trading. Lower tax rates on LTCG also contribute to increased returns by saving taxes.
Reduction of Market Timing Risk: Short-term fluctuations in the market are not a big deal to long-term investors. This way, they can avoid short-term market changes and instead concentrate on the long-term market growth.

Conclusion

The new tax structure of LTCG announced in the 2024 Union Budget brings new possibilities for mutual fund investors, especially for those who are seeking long-term gains. The concept of holding periods, rate of taxes, and exemptions also make it possible for one to choose better investment avenues since one gets to understand when it is more appropriate to sell an investment in order to cut down tax liabilities.

Maintaining mutual units in the portfolio for the longer term yields substantial tax advantages and with the new changes in the tax structure, the investor can gain more tax advantages.

FAQs:

1. Is TDS applicable on sales of shares or mutual funds?

No, there is no TDS on the sale of stocks or mutual funds for Indian tax residents.

2. Is capital gains tax applicable to senior citizens on mutual fund investments?

Senior citizens also bear capital gains tax on mutual funds and other investments just like any other citizen in the country. It is important to note that the tax rules with regard to capital gains are not categorized according to the age of the taxpayer.

3. When is capital gains taxable?

Even if you have not withdrawn the funds from your mutual funds or stocks, capital gains tax is charged in the financial year in which you sold your mutual fund units or shares.

4. In what category, Capital Gains or Ordinary Income, are Mutual Fund returns taxed?

Income from all equity and debt mutual funds is considered capital gains either STCG or LTCG depending on the holding period.

5. Which Mutual Fund returns are tax-free?

At present, capital gains arising from mutual funds whether short term or long term are charged under the respective provisions of Section 73.