Why is the hype around mutual funds? Regardless of the risks, what makes people want to invest in them much more? Maybe we can answer this like Robert Arnot,
“In Investing – what is comfortable is hardly profitable.”
Where there are risks – there are always rewards. So, this is the secret behind everyone following the path of mutual funds. Well, investing in the stock market could be a great way to get started for amazing rewards, but for new investors, it’s never an easy task, or compiling enough funds. Mutual funds make it easier; they give you capital gain distribution and dividend payouts. In this post, let’s learn about capital gains distribution, shall we?
What is Capital Gains Distribution?
Capital gain distribution is the payment by mutual funds of a portion of the proceeds from the fund’s sale of stock and assets within the portfolio. It is a pro-rata share of the proceeds from the transaction of the fund.
The capital gains distribution should not be mistaken for the overall profit. Of course, the investor may gain or even lose money based on the market.
For Example;
You are a new investor in the market, so you choose a reputed business, let’s say HDFC. Now, you choose the HDFC balanced advantage fund from there. While you stay invested for a while, the Capital Gains Distribution goes up by 36%; what would be your next move? Would you think that you have profited? Your fund has risen, but that isn’t permanent.
After that, let’s say you wait for two days to sell your mutual fund and withdraw the investment and returns. But, in the course of two days, your fund could have either dropped or risen based on the stock market movements.
This must have given you a clear picture of capital gains distribution.
Let’s Understand Capital Gains Distribution a Little More In-Depth
A mutual fund or ETF typically distributes capital gains at the end of each year. The distribution represents the revenues of the fund’s managers’ sales of stock or other assets throughout the tax year.
The investor should remember that cashing out the capital gains payout rather than reinvesting it in the fund is basically a withdrawal.
It deducts the amount of the distribution from the net amount you have invested in the fund.
So now, let’s come to the point of understanding how the returns are taxed in India. But, before that, you will have to know the types of returns you will get from a mutual fund.
Types of Returns from Mutual Fund Investments
There are mainly two types of returns from mutual fund investments, and they are:
Capital Gains: The profit made on the selling of an asset, such as a mutual fund, is referred to as capital gain. When the selling price of an item exceeds the buying price, it results in a capital gain. It is the difference between the asset’s selling price (higher) and cost price (lower).
Dividends: A dividend is a monetary or non-monetary incentive given by a firm to its shareholders.
What is the Difference Between Both Types of Returns? Capital Gains and Dividends
- The distribution of mutual fund capital gains occurs in response to the profitable sale of stocks or other securities. A mutual fund dividend is money produced by the fund from dividends and interest paid on its holdings.
- Gain distribution occurs once a year. Dividends, on the other hand, are paid quarterly or annually.
- In most cases, a fund manager or investor determines whether or not to sell the equities in order to realize the gains. Companies, on the other hand, make dividend decisions.
How are Capital Gains Distribution Taxed?
The tax rate on mutual fund capital gains is determined by the holding period and kind of mutual fund. Capital gains realized by selling mutual fund units are classified as follows:
Equity funds – Capital gains of up to Rs 1 lakh per year are tax-free. Any long-term gains in excess of this ceiling are subject to a 10% LTCG tax with no indexation advantage.
Debt funds – Debt fund gains will be added to your taxable source of income and taxed at the slab rate. Long-term capital gains from debt funds were previously taxed at 20% with an indexation benefit.
Hybrid funds – The tax rate on capital gains on hybrid or balanced funds is determined by the portfolio’s equity exposure. If the equity exposure exceeds 65%, the fund plan is taxed as an equity fund; otherwise, debt fund taxation rules apply.
Mutual funds’ short-term and long-term capital gains are taxed at various rates, so you might want to go ahead and check the official website or current rates to always be sure.
How to Keep Away from These Taxes?
There are two main ways to lessen the taxation burden on yourself:
a) If you possess mutual funds in a taxable account, capital gains distributions result in a tax bill, but they have no effect on retirement accounts. When you reinvest your profits, they are added to your cost basis, lowering your taxable gain when you sell the fund.
b) Visit your fund company’s website in early October each year to learn whether and when capital gains distributions will be made. If you anticipate big distributions, weigh the benefits and drawbacks of owning the fund. You could desire to liquidate the fund to avoid the distribution and the resulting tax burden.
Note: Aside from the dividend and capital gains taxes, there is also the Securities Transaction Tax (STT). When you buy or sell mutual funds of an equity fund or even a hybrid equity-oriented fund, the government charges an STT of 0.001%. The selling of debt fund units is exempt from STT.
Bottom-Line
No one wants to go on a big surprise when the returns come in – such as seeing a whole lot of taxes to be paid. Instead, when you know how the taxes are calculated and what you would have to do in order to keep the ball in your court – it makes things much lighter on your end.
