Capital Gains Tax on Mutual Funds Explained: Equity vs Debt, LTCG vs STCG

While most investors focus on selecting the right mutual fund, what often gets overlooked is when you choose to redeem. That single decision can quietly reshape your final returns through capital gains tax. Depending on your holding period and whether it's an equity or debt fund, the tax you owe can vary significantly, sometimes eating into a meaningful chunk of your profits.

Changes in tax treatment, especially recent shifts for debt funds, have made it harder to navigate without a clear understanding. Knowing how and when capital gains apply empowers you to make informed exit decisions and preserve more of what you’ve earned.

Key Takeaways:

• Capital gains tax on mutual funds depends on the fund type (equity or debt) and the duration of your holding period before redemption.

  
  

• Equity mutual funds are taxed at 20 percent if sold within 12 months and at 12.50 percent on gains above ₹1 lakh if held longer, with no indexation benefit.

  
  

• All gains on debt mutual funds purchased after April 1, 2023 are treated as short-term and taxed according to your income tax slab, regardless of holding period.

  
  

• Debt fund investments made before April 1, 2023 continue to qualify for long-term tax treatment with 20 percent tax and indexation benefit if held for over 36 months.

  
  

• Planning your exit strategy carefully can help reduce the impact of taxes and preserve more of your mutual fund returns.
  

What is Capital Gains Tax on Mutual Funds

Capital gains tax on mutual funds is the tax you pay on the profit earned when you redeem your mutual fund units at a price higher than your purchase cost. This profit is known as a capital gain, and it's taxed based on two key factors:

1. Type of Mutual Fund

Equity Funds: Funds investing 65% or more in equity shares

Debt Funds: Funds primarily investing in bonds, debentures, or money market instruments

2. Holding Period

1. Short-Term Capital Gains (STCG):

- Equity: Held for 12 months or less

2. Long-Term Capital Gains (LTCG):

- Equity: Held for more than 12 months

Key Insight:

Tax on mutual fund gains is not applied while you're holding the investment. It’s triggered only when you sell, switch, or redeem the units.

Short-Term Capital Gains (STCG)

Short-term capital gains tax applies when mutual fund units are sold within a specific holding period. The tax rate and rules depend on whether the mutual fund is equity-oriented or non-equity.

1. Short-term capital gains tax on equity mutual funds:

• Equity mutual fund units sold within 12 months of purchase are classified as short-term capital gains.

• These gains are taxed at a flat rate of 20%, regardless of the investor’s total income.

• There is no basic exemption; the full amount of the gain is taxable from the first rupee.

• A 4% health and education cess is added to the tax, and a surcharge may apply for investors with income above ₹50 lakh.

Example:

An investor redeems ₹5,40,000 from an equity fund purchased for ₹5,00,000 within 11 months. The ₹40,000 gain is taxed at 20% plus cess.

2. Short-term capital gains tax on non-equity mutual funds (including debt funds):

• As of April 1, 2023, all gains from non-equity mutual funds are treated as short-term capital gains, regardless of the holding period.

• These gains are taxed at the investor’s applicable income tax slab rate.

• Indexation benefits, which were previously available for long-term gains on debt funds, no longer apply for new investments.

Example:

A ₹60,000 gain on a debt mutual fund held for 2 years is added to taxable income and taxed according to the investor's slab rate (e.g., 30%).

Important clarification:

Since gains from non-equity funds are added to total income, investors in higher tax brackets could pay up to 30% (plus cess) in tax. This makes slab rate awareness crucial when investing in or redeeming debt mutual funds.

Long-Term Capital Gains Tax (LTCG)

Long-term capital gains tax applies when mutual fund units are sold after being held beyond a specific minimum duration. The tax treatment varies based on whether the mutual fund is equity-oriented or not.

1. Long-term capital gains tax on equity mutual funds:

• Equity mutual fund units sold after being held for more than 12 months are classified as long-term capital gains.

• Gains up to ₹1 lakh in a financial year are exempt from tax.

• Gains exceeding ₹1 lakh are taxed at a flat rate of 12.50%, with no indexation benefit.

• The ₹1 lakh exemption resets every financial year and applies across all equity mutual funds combined.

Example:

If an investor earns ₹1.4 lakh in long-term capital gains from equity funds in a year, ₹1 lakh is exempt. The remaining ₹40,000 is taxed at 12.50%, resulting in ₹5,000 tax (plus cess).

2. Long-term capital gains tax on non-equity mutual funds (debt, gold, international):

• For investments made on or after April 1, 2023, all gains from non-equity mutual funds are treated as short-term gains, even if held for more than three years.

• Long-term classification and indexation benefits are no longer available for these newer investments.

• Earlier investments (before April 1, 2023) still qualify for LTCG treatment if held for more than 36 months, and those gains are taxed at 20% with indexation.

Example:

If a debt fund bought before April 2023 is redeemed after 4 years and yields ₹1,00,000 in indexed gains, the taxable amount is ₹1,00,000 at 20%, leading to ₹20,000 tax (plus cess).

How to Calculate Capital Gains on Mutual Funds

Capital gains on mutual funds are calculated by subtracting the purchase price (adjusted, if applicable) from the sale price of the units. The process depends on whether the gains are short-term or long-term and whether the investment qualifies for indexation.

For equity mutual funds:

1. Identify the units sold and their purchase price (use FIFO method).

2. Subtract the purchase value from the sale value to find the gain.

3. If held for 12 months or less, classify as STCG and apply 20% tax.

4. If held for more than 12 months, classify as LTCG.

5. Apply ₹1 lakh exemption, then tax the remaining at 12.50%.

Example:

• Purchase price: ₹2,00,000 (Jan 2022)

• Sale price: ₹3,20,000 (Feb 2024)

• Gain: ₹1,20,000

• Exemption: ₹1,00,000

• Taxable LTCG: ₹20,000 × 12.50% = ₹2,250 (plus cess)

For debt mutual funds (post-April 2023):

1. All gains are treated as STCG, regardless of holding period.

2. Gains are added to your income and taxed as per slab.

Example:

• Purchase price: ₹5,00,000 (May 2023)

• Sale price: ₹5,60,000 (May 2025)

• Gain: ₹60,000 added to income and taxed at your slab rate

For older debt investments (before April 1, 2023):

1. If held for more than 36 months, apply cost inflation index (CII) to the purchase price.

2. Subtract the indexed purchase price from the sale price.

3. Tax the indexed gain at 20%.

Conclusion

Capital gains tax rules evolve with every budget and regulatory update. A fund that once offered tax efficiency may no longer provide the same benefits under new rules. Staying informed about these changes is not just a matter of compliance but it is essential to effective portfolio management. Choose an experienced mutual fund advisor who goes beyond product selection and helps you optimize the withdrawal strategies and minimize tax impact to preserve overall returns.

FAQs

How is capital gains tax calculated on mutual funds?

It’s the profit you make when you sell your mutual fund. Equity funds: 20% tax if sold within 1 year, 12.50% if held for over 1 year (only if profit crosses ₹1 lakh). Debt funds: tax depends on how long you held them and when you bought them.

How to save tax on mutual funds gains?

Hold equity funds for over a year and keep gains under ₹1 lakh a year to save tax. You can also invest in ELSS funds to get ₹1.5 lakh tax deduction under Section 80C.

Which LTCG is taxed at 20%?

Profits from debt funds bought before April 1, 2023, are taxed at 20%, but you get inflation benefit, so actual tax paid may be much lower.

How much mutual fund gain is tax free?

Up to ₹1 lakh profit per year from equity mutual funds is tax free, if you hold them for more than 1 year.

How to calculate LTCG on mutual funds?

Just subtract your buying price from the selling price. If it’s an equity fund and you held it for more than 1 year, tax is 12.50% only on profits above ₹1 lakh.