There is no doubt that mutual funds have become sort of a commodity in this ever growing market of investments and finance. With investments beginning from as low as Rs. 500/-, mutual fund are getting huge attention of institutional as well as retail investors and the corpus is growing everyday.
Mutual funds do not need a large initial investment. Also, if you shop sensibly, you can limit how much you have to pay to own them. But there definitely is one thing that not all mutual funds are tax friendly.
Taxes that MF shareholders pay
Mutual fund shareholders usually pay federal and, in many cases, state and local income taxes, including taxes on dividends and capital gains. Stockholders who own mutual funds outside of tax advantaged accounts are taxed every year. They are taxed on 2 types of transactions – distributions from the fund and the sale of the fund shares. We shall learn the significant types of taxation of mutual funds.
How are Mutual Fund Dividends taxed?
If you are thinking to buy mutual funds that pay dividends, it’s clever to know how dividends are taxed before buying. You may even agree that dividend funds are not the best funds to buy for your investment objectives or tax situation.
When Are the MF Dividends Taxed?
It is significant to note first that mutual fund shareholders can be taxed on an asset’s dividend, also if distributors these distributions are received in cash or reinvested in additional shares of the fund. For some tax deferred and tax advantaged accounts, for instance an IRA, 401(k) or annuity, dividends are not taxable to the investor while held in the account. In its place, the investor will pay income taxes on withdrawals during the taxable year the distribution (withdrawal) is made.
For taxable accounts, say individual and joint brokerage accounts, MF dividends are usually taxed in the form of ordinary income (which is taxed at the individual income tax rate) or as qualified dividends (taxable up to a 15% maximum rate).
For instance and an idea of stats, tax year 2016, which they need to know for their tax filing due in April of 2017, here are the tax rates for dividends:
- Income Brinks: Individuals and marital taxpayers in the 10% and 15% tax brackets will pay 0% on eligible dividends and most capital gains.
- Qualified Dividends: Received Income will be taxed at the equal rate as long-term capital gains.
- Tax Rate: Individuals lying in the 25%, 28%, 33%, and 35% federal income tax brackets will pay 15% on capital gains, whereas taxpayers in the 39.6% bracket will pay 20%.
DISTRIBUTIONS AND YOUR TAXES:
In case you hold shares in a taxable account, you are needed to pay taxes on mutual fund distributions, whether the distributions are paid out in cash or reinvested in additional shares. The assets report distributions to shareholders in IRS Form 1099-DIV after the end of every calendar year. For any time during the year you bought or sold shares in a mutual fund, you must report the transaction on your tax return and pay tax on any gains and dividends. Moreover, as an owner of the shares in the fund, you must report and potentially pay taxes on transactions conducted by the fund (whenever the fund sells securities)
In case you compare various mutual funds at the same company, it may not feel like you received your money back and then reinvested it. Though, the transactions are treated like any other sales and purchases, and so you must report them and pay taxes on any gains. We will look at the types of distribution and the type of taxes associated with it:
| Kind of distribution | Federal income tax treatment |
| Long-term capital gain | Subject to the capital gains rates, usually lower than the ordinary income tax rates |
| Short-term capital gain | May be treated as ordinary dividends, thus taxable at ordinary income tax rates |
| Qualified dividend | Normally taxed as long-term capital gains (subject to certain holding period and hedging restrictions) |
| Ordinary or non-qualified dividend | Taxable at ordinary income tax rates |
| Tax-exempt interest | Not taxable for federal tax purposes; may be subject to state and/or local taxes, depending on your resident state and the type of bonds purchased |
| Taxable interest | Taxable at ordinary income tax rates |
| Federal interest | Taxable at ordinary federal income tax rates, but exempt from state income tax |
| Required distributions | Taxed as ordinary income |
| Return of capital | Not taxable |
In case of when there is no distribution:
If a MF does not have any principal gains, dividends, or other payouts, no distribution could occur. There could also be a non-taxable distribution. Shareholders will not be needed to pay taxes if the fund has not completed a taxable distribution, and shareholders will not receive a Form 1099-DIV for that fund.
Securities Transaction Tax (STT):
In the case of equity mutual funds in which investments have been carried out for more than a year, a Securities Transaction Tax is levied on the amount that is redeemed. It is a very small amount and as evident from the image above, is usually 0.001% of the amount that is to be redeemed.
FAQs
Like income from the sale of any other investment, if you have owned the mutual fund shares for a year or more, any profit or loss generated by the sale of those shares is taxed as long-term capital gains. Otherwise, it is considered ordinary income.
How do you avoid double taxation on mutual funds? ›
But the capital gain includes the reinvested dividends, on which the investor already paid taxes. So, the investor may end up paying taxes twice on the same earnings. To avoid paying taxes twice, the investor needs to adjust the cost basis of their investment.
How to tell if a mutual fund is tax-efficient? ›
Look for funds that distribute fewer gains, as this indicates better tax management. Additionally, check if the fund employs tax-loss harvesting strategies. This involves selling losing investments to offset gains, thereby reducing taxable income. You should also consider the fund's structure.
How to calculate tax on mutual funds? ›
When you sell your equity fund units after holding them for at least a year, you realize long-term capital gains. These capital gains are tax-free, up to Rs 1.25 lakh per year. Any long-term capital gains over this threshold are subject to a 12.5% LTCG tax, with no benefit of indexation.
How do I avoid tax on mutual fund returns? ›
Here are some strategies to consider to avoid long term capital gain tax (LTCG) on mutual funds: Systematic Withdrawal Plan (SWP): Set up an SWP to automatically redeem your mutual fund units regularly. By keeping withdrawals below Rs. 1 lakh per year, you may avoid LTCG tax altogether.
Do you pay capital gains on mutual funds every year? ›
Generally, mutual funds distribute these net capital gains to investors once a year. Capital gains are taxable income, even if you reinvested the money. You'll probably get an IRS Form 1099-DIV in January showing your portion of the fund's capital gains during the previous year.
What is the problem with taxation of mutual funds? ›
When looking at the 10 largest mutual funds by asset size, the turnover ratio is almost 75% (1). This means investors will pay higher taxes in the form of distributions due to mutual fund managers selling or buying 75% of the stocks that make up their fund annually.
How to avoid the mutual fund tax trap? ›
Consider swapping out your mutual funds for exchange-traded funds (ETFs). ETFs may be more tax-efficient than mutual funds because the underlying securities in the fund are often traded "in-kind," that is, swapped for another security of similar value rather than sold outright.
Can I move money from one mutual fund to another without paying taxes? ›
If you move between mutual funds at the same company, it may not feel like you received your money back and then reinvested it; however, the transactions are treated like any other sales and purchases, and so you must report them and pay taxes on any gains.
Do I have to pay taxes on money I take out of a mutual fund? ›
You must pay taxes on dividends, interest, and capital gains that the fund company distributes to you, in addition to capital gains on sale or exchange of shares in your account. Reinvesting distributions in more shares of the fund does not relieve you from having to pay taxes on those distributions.
Under Section 80C of the Income Tax Act, tax benefits are applicable in the case of ELSS or Equity Linked Saving Schemes. You can get up to Rs.1.5 lakh in tax deduction and save around Rs.46,800 each year on taxes. One should remember that ELSS has a minimum lock-in period of three years.
Which mutual fund is best for tax? ›
List of Top Tax Saving Mutual Funds in India sorted by Returns
- Quant ELSS Tax Saver Fund. EQUITY ELSS. ...
- SBI Long Term Equity Fund. EQUITY ELSS. ...
- Bank of India ELSS Tax Saver Fund. EQUITY ELSS. ...
- Motilal Oswal ELSS Tax Saver Fund. ...
- JM ELSS Tax Saver Fund. ...
- HDFC ELSS Tax Saver Fund. ...
- DSP ELSS Tax Saver Fund. ...
- Bandhan ELSS Tax Saver Fund.
You are allowed to invest up to Rs 1.5 lakh in tax-saving funds. You will get a tax deduction of up to Rs 1.5 lakh under Section 80C of the Income Tax Act. a. ELSS funds are the only tax-saving funds within the Rs 1.5 lakh limit which has the additional advantage of giving equity-linked returns.
How do I claim tax on mutual funds? ›
Dividend income needs to be reported every quarter in the ITR form. Mutual fund houses will deduct TDS u/s 194K @ 10% when the dividend exceeds Rs 5000. Such TDS amount will be reflected in your form 26AS which can be claimed as Tax credit at the time of filing your ITR.
How to show mutual fund investment in income tax return? ›
How to Show Mutual Fund Investment in ITR? To show your mutual fund investments in your ITR: Capital Gains: In ITR-2 or ITR-3, under the section "Schedule CG," you need to provide details of the sale of mutual fund units, including the purchase price, sale price, and period of holding.
How are mutual funds treated in income tax? ›
Taxation of Mutual Funds
| Fund Type | Tax rates (If Purchased Before 31 March 2023) |
|---|
| Balanced Hybrid Funds (Equity: 40%-60% Debt: 60%-40%) | 36 months | 20% with indexation |
| Aggressive Hybrid Funds (Equity: 65%-80% Debt: 35%-20%) | 12 months | 10% without indexation |
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The funds report distributions to shareholders on IRS Form 1099-DIV after the end of each calendar year. For any time during the year you bought or sold shares in a mutual fund, you must report the transaction on your tax return and pay tax on any gains and dividends.
Are mutual funds bad for taxable accounts? ›
Mutual funds are a popular investment option for many reasons, but they can actually create a significant tax burden in some cases. Because individual investors do not have any control over the investment activity of a mutual fund, it is important to ensure your mutual fund is tax-efficient.
What are tax-exempt mutual funds? ›
Tax-Exempt Funds
Because tax-exempt mutual funds are comprised of government-issued bonds, which are virtually risk-free, they tend to have much lower rates of return than funds that include more volatile securities. For some, the tax benefits of these assets outweigh their reduction in earning potential.
