Tax liability on Mutual fund returns

Hi all. Lets see the taxation part on the capital gains or profit earned on mutual funds. Many are not aware or find it confusing due to the terms such as long term capital gain or indexation.

Tax liability is an important aspect of Mutual funds. All types of capital gains on mutual funds are taxable. Capital gain is the difference between the purchase price and sale price of an investment. Tax rules vary for short and long term capital gain investments depending on type of fund and duration of investment.

For equity based funds (equity component greater than 65%), short term capital gains are gains obtained up to 1 year of investment. The gains on investments for more than 1 year are considered as long term capital gain. Equity funds are taxed at the rate of 15% for short term capital gain. Long term capital gain is taxed at 10%, if capital gain is more than 1 lakh. If capital gain is less than 1 lakh, its tax free. Please note that indexation benefit is not applicable for long term capital gains on equity funds. Indexation is applicable for long term capital gains in debt funds only. 

Now what exactly indexation means ?

Indexation in mutual funds consists of adjustment in capital gains considering cost inflation index in order to reduce taxes. In simple words, taxable capital gain is calculated after deducting the inflation value from capital gain, which represents the realistic capital gain that can be taxed. 

Inflation is a sustained increase in the price level of goods and services in an economy over a period of time. It is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling and is measured as an annual percentage change. 

For debt funds, short term capital gains are gains obtained up to 3 year of investment. The gains on investments for more than 3 year are considered as long term capital gain. Debt funds are taxed as per income tax slab rate for short term capital gain. Long term capital gains are taxed at the rate of 20% after considering indexation. That means the taxable capital gain will reduce after deducting the inflation value in the form of Indexation.