Mutual Funds Taxation: Changes in Budget FY2024-25

Finance Minister Nirmala Sitharaman made some major changes in the tax structure of mutual funds in the Union Budget 2024-25 including a major unexpected hike in long-term capital gains tax on equity mutual funds.

However, the budget also proposed several changes to aid the simplification of taxes with respect to mutual fund categories. For taxation purposes, mutual funds have been divided into 3 categories:

First: Equity funds or funds with more than 65% equity assets. Some examples of these funds include diversified equity funds, flexi cap funds, aggressive hybrid funds (with over 65% exposure to equities), midcap funds.
Tax structure – They will be taxed as capital assets – 20% tax on short-term gains and 12.5% on long-term gains, meaning if they’re held for more than 12 months.
Second: Debt funds or funds with over 65% assets in debt securities. Liquid funds, money market funds, overnight funds, ultra short-term funds, short-duration funds, long-duration funds, corporate bond funds, Banking and PSU funds, gilt funds, 10-Y constant maturity gilt funds, conservative hybrid funds as some examples of funds that will fall under this category.
Tax structure – They will be taxed as per your tax slab, irrespective of whether they are held for short term or long term. So there’s no concept of short or long term for debt funds anymore.
Third: Other mutual funds that don’t fall under either equity or debt category. Some examples are gold funds or gold exchange traded funds (ETFs), silver funds & ETFs, a fund of fund (FoF) or an international fund or hybrid fund.
Tax structure – These will be taxed as per your income tax slab if they’re held for the short term and 12.5% if they are long term, which means if they are held for more than 2 years.

Other changes in mutual fund taxation:

Increase in exemption limit for LTCG tax from ₹1 lakh to ₹1.25 lakhs. This means that if your long-term gain is less than ₹1.25 lakh, you would be exempt from paying any capital gains tax.
For the second and third categories of mutual funds, namely the debt funds and other funds, long-term capital gains tax will apply if you hold them for more than 24 months, as against 36 months earlier.
Indexation benefit has been removed from all mutual funds. Indexation was a helpful tool for investors, which allowed them to increase their purchase price to account for inflation, consequently leading to lower capital gains.

Let’s see how your gains from mutual funds will be impacted after these changes.

Let’s assume you made an investment of ₹25 lacs in equity mutual funds in June 2023. By July 2024, the value of your investments went up to ₹40 lacs. Let’s see how the current changes in taxation will impact the net gain from your investments.

From the above illustration, we can see that after the hike in LTCG tax on mutual funds from 10% to 12.5%, your tax liability has gone up by ₹31,875, despite the increase in exemption limit from ₹1 lakh to ₹1.25 lakhs. This equates to a 22.8% increase in your tax liability on the same gain of ₹15 lacs from your mutual fund investment.

However, if your earnings are less than ₹2.25 lakhs, the new regulation will be advantageous for you. The increase in exemption by ₹25,000 will offset the increase in your tax. For instance, if your earnings are ₹2 lakh, your tax liability under the old tax regime would be ₹10,000. However, with the new regulation, it would slightly decrease to ₹9,375, resulting in a saving of ₹625 for you.

Which funds have been most impacted?

In this budget, the tax on equity mutual funds has been hiked. Your gains from equity funds will now be taxed higher whether you hold them for the long term (from 10% to 12.5%) or for the short term (from 15% to now 20%). Taxation on debt funds remains unchanged.

The third category which includes Gold ETFs and international funds get a benefit in this budget. The long-term tax on them is reduced to 12.5%, instead of being taxed as per your income tax slab rate.

The increased exemption limit to ₹1.25 lacs on LTCG will benefit small investors, which will augur well for the mutual fund industry overall.

When will the new taxation rules come into force?

You will be taxed as per the new structure on all redemptions made on or after 23rd July 2024.

Should the tax changes in mutual funds impact your investment strategy?

Equity as an asset class is known to have delivered the best long-term returns. While the change in tax structure for mutual funds may eat away your profits a little, they still offer an attractive investment opportunity compared to other asset classes. Besides, an investor’s asset allocation should be guided mainly by their financial goals and risk tolerance, rather than tax considerations

Rather than worrying about taxes, it would be a good idea for investors to review their portfolio and make sure the funds they have invested in align with their investment goals, have a healthy portfolio and have a strong track record.