Most investors check past returns before investing in mutual funds. Some compare ratings. A few study fund managers. But taxation is often ignored — even though it directly affects the money you actually take home.
If two investors earn the same return but one plans taxes better, that investor keeps more. It is that simple.
Here is a clear explanation of how mutual funds are taxed in India under the current rules applicable in FY 2025–26.
When Is Tax Applicable?
You do not pay tax when you invest in a mutual fund. Tax applies only when:
- You redeem your units
- You switch from one scheme to another
- You receive dividend under the IDCW option
The amount of tax depends mainly on:
- The type of mutual fund
- The holding period
- Your income tax slab
Taxation of Equity Mutual Funds
A mutual fund is considered equity-oriented if at least 65 percent of its portfolio is invested in Indian equities.
If you sell equity mutual fund units within 12 months, the profit is treated as short-term capital gain and taxed at 20 percent.
If you hold them for more than 12 months, the profit becomes long-term capital gain. Long-term gains above Rs 1.25 lakh in a financial year are taxed at 12.5 percent. Gains up to Rs 1.25 lakh are exempt.
This structure rewards long-term investing and discourages frequent trading.
Taxation of Debt Mutual Funds
Debt funds invest in bonds and other fixed-income securities.
For investments made on or after April 1, 2023, gains from most debt mutual funds are taxed according to your income tax slab, irrespective of how long you hold them.
There is no long-term benefit and no indexation advantage for these investments.
If you are in the 30 percent tax bracket, your gains will be taxed at 30 percent.
Taxation of Hybrid Funds
Hybrid funds invest in both equity and debt.
- If equity allocation is 65 percent or more, the fund is taxed like an equity fund.
- If equity allocation is below 65 percent, it is taxed like a debt fund, meaning gains are added to your income and taxed as per your slab.
Always check asset allocation before assuming tax treatment.
ELSS and Section 80C Benefit
Equity Linked Savings Schemes (ELSS) allow you to claim deduction up to Rs 1.5 lakh under Section 80C.
They have a mandatory lock-in of three years.
After the lock-in, gains are taxed as equity long-term capital gains. The same 12.5 percent tax applies on gains exceeding Rs 1.25 lakh.
Dividend Taxation
If you choose the IDCW option, any dividend received is added to your total income and taxed according to your slab rate.
For long-term investors, the growth option is often more tax-efficient because tax is deferred until redemption.
How SIP Is Taxed
Each SIP installment is treated as a separate investment.
Each installment has its own purchase date and holding period.
When you redeem, some units may qualify as long-term and some as short-term. Tax is calculated separately for each.
Switching Funds
Switching from one scheme to another is treated as redemption of the old scheme.
Capital gains tax applies at the time of switching.
Set-Off of Losses
- Short-term capital losses can be adjusted against both short-term and long-term gains.
- Long-term capital losses can be adjusted only against long-term gains.
- Unadjusted losses can be carried forward for up to eight years if the return is filed on time.
Final Thought
Taxation is not something to fear, but something to understand.
Equity funds remain relatively tax-efficient for long-term investors. Debt funds are taxed at slab rates and require careful evaluation. Proper planning can improve your post-tax returns significantly.
Frequently Asked Questions
How much tax do I pay on mutual funds?
It depends on the fund type and holding period. Equity funds are taxed at 20% (under 1 year) or 12.5% above ₹1.25 lakh. Debt funds are taxed as per your income slab.
How do I avoid tax on mutual funds?
You can't fully avoid tax, but you can reduce it by holding equity funds over 1 year, using the ₹1.25 lakh LTCG exemption, and investing in ELSS under 80C.
What is the 7/5/3-1 rule in mutual funds?
It's not a tax rule. It's an investing guideline suggesting long-term holding (5–7 years), diversification across 3–5 funds, and regular portfolio review.
Is SIP in mutual fund tax free?
No. SIP is just a way of investing. Each installment is taxed based on the fund type and how long you hold that specific investment.