How are Mutual Funds taxed?

Similar to a residential property, mutual funds fall under the capital asset class and hence the tax laws of capital assets are applicable to units of mutual funds held by an individual. A mutual fund may generate income during its holding period in the form of dividends or bonus units. It could also provide capital appreciation in the long run resulting in capital gains when redeemed or sold. And as with other capital assets, it could be gifted or bequeathed to legal heirs as per one’s will or per intestate laws, whichever is applicable.

Tax classification
As a large variety of funds exist, we need to understand the subclasses under which a particular fund falls so we could determine whether it would qualify for lower taxation or any eligible tax exemptions provisioned. Broadly funds are offered to investors with a dividend or growth option.

Any periodic income received under dividend option of a mutual fund is taxable while dividends directly received by holding of stocks are tax-exempt. However such taxes on these dividends are deducted upfront by Mutual Fund houses (as DDT – Dividend Distribution Tax) and hence not directly taxed in the hands of the investor. The growth option does not provide any periodic income and hence could result only in capital appreciation.