Mutual fund redemption and taxation

Unlike fixed deposits (FDs), where the accrued interest is taxed every year, gains from mutual funds are taxed only when they are realised, i.e., at the time of redemption. For example, if one invests in an FD for five years and accrues interest every year as - Rs 1,000 in the first year, Rs 1,100 in the second, and so on, these amounts add to the taxable income and are taxed according to the tax slab. If the investor falls in the 30 per cent tax bracket, a tax of 30 per cent is to be paid.

In the case of mutual funds, let's say, if an amount of Rs 1 lakh is invested and the value increases to Rs 1.07 lakh by the end of the first year, and the amount is not redeemed, then tax is not counted on that Rs 7,000. Next year, it further increases to Rs 1.15 lakh, and if it is not redeemed - again no tax. In the third year, when the value rises to Rs 1.18 lakh, and the investor plans to redeem Rs 50,000, then the gains made from this redemption will be taxed.

Redemption is as per the first-in-first-out (FIFO) method for mutual funds. Units that are bought first are redeemed first. For example, if you bought 100 units in 2017, and 150 units in 2018, in total you now have 250 units. After a few years, if you wanted to sell 80 units, the units that were bought in 2017 are sold first. The next time you want to sell 100 units, the 20 units of 2017 and 80 units of 2018 are sold. This is how the FIFO method works.

Your debt mutual fund redemption will qualify for long-term capital gains tax if your units are held for more than three years (36 months). The long-term capital gains tax will be 20 per cent with the inflation indexation benefit. If your investments are redeemed before three years (36 months), the short-term gains will be taxed as per your applicable income tax slab.

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