The Indian mutual fund industry is surpassing new heights as more investors turn to Systematic Investment Plans (SIPs) to create wealth. As more and more people become aware of the power of disciplined investing and compounding interest, SIPs have emerged as the go-to choice for all kinds of investors. Understanding how SIPs work and are taxed thus becomes essential for making sound investment decisions.
So is SIP tax free? The straight answer is no, as they attract tax on capital gains and dividends. But a well-made investment plan can make SIPs highly tax-efficient compared to investment vehicles like fixed deposits. In this article, we’ll cover all things related to SIP taxation – From rates, exemptions, deductions, and benefits to strategies that can help you save as much tax on SIP investments as possible.
Is SIP Tax-free?
No, income earned from mutual funds is taxable. The tax treatment, however, depends on the type of fund, the investment’s holding period, and the type of income earned.
Type of Income
There are two ways to earn income from a mutual fund investment, and each is taxed differently.
1. Capital gain income
When you redeem your fund’s units (or sell them on a stock exchange or closed mutual fund schemes), the profit earned is called capital gains. This is simply the difference between the purchase price and the selling price.
2. Dividend income
In case you invest in an SIP with the IDCW (Income Distribution cum Capital Withdrawal) option, the regular income you earn is taxed like dividends.
Type of Fund
The tax treatment of mutual fund income also depends on the type of fund you invest in. Different mutual funds are taxed at different rates based on whether they are equity-oriented or debt-oriented.
1. Equity-oriented funds
According to SEBI, a fund is classified as equity-oriented if it invests at least 65% of its assets in stocks or equity-related instruments. So pure equity funds as well as hybrid funds with at least 65% assets allocated to equities are considered equity-oriented funds for taxation purposes. Examples of such hybrid funds include equity savings schemes, which invest only around 30 to 40% of assets in stocks, but due to their arbitrage allocation qualify for equity-like taxation.
2. Debt-oriented funds
If less than 65% of a mutual fund’s assets are allocated to equity, it is classified as a debt-oriented fund. This includes pure debt schemes like liquid funds, as well as debt-oriented hybrid funds.
Holding Period
This refers to how long a mutual fund investment was held before being sold or redeemed. Based on the holding period, capital gains are classified into long-term capital gains (LTCG) or short-term capital gains (STCG). Both equity as well as debt mutual fund SIPs follow different tax rules based on their holding period. We’ll take a look at them in the sections that follow.
An important point to note here is that for lump sum investments, estimating the holding period is quite straightforward, but that’s not the case with SIPs. Every SIP instalment counts as a separate investment and is thus subject to its own holding period for tax calculation purposes.
So is SIP investment tax free? No, but are there ways to make SIPs more tax-efficient? Yes, absolutely! Read on to learn how you can minimise taxes and maximise returns through tax saving SIP investments.
What are SIPs?
SIP is short for Systematic Investment Plan. Through this mode, investors can contribute a fixed amount regularly into a mutual fund scheme of their choice. Instead of making a large lump sum payment, SIPs allow you to take a disciplined approach and invest your savings systematically. You can make your regular investment at any interval that suits you. If you want to invest in an SIP monthly or yearly, quarterly or semi-annually, you have the flexibility to choose a frequency that aligns with your financial goals and income. Before going into income tax on SIP, let’s first check out some reasons why you should be investing in them.
Benefits of SIP
- SIPs allow investors to contribute a fixed amount regularly which makes investing easier and helps build wealth slowly through disciplined investing.
- Growth-oriented SIPs reinvest their earnings and benefit from compounding interest. Over the long term, your returns earn their own interest and grow your wealth.
- Since the investment is made on a predetermined date, the need to time the market is eliminated. As the market goes through ups and downs, investors can benefit from an effect known as rupee cost averaging. When the fund’s NAV is low, more units can be bought, and when it’s high, the same amount buys fewer units. This reduces the effect of volatility and also the cost of investment.
- SIPs offer an affordable way to participate in the growing Indian economy.
- Most mutual fund houses allow you to alter the investment amount and temporarily pause your SIPs. As your financial circumstances change you can easily adapt your SIP contributions to reflect them.
Taxation of Capital Gains from SIPs
Capital gains taxation on mutual fund SIPs depends on the category of mutual fund and the holding period of the investment.
Capital Gains Tax on Equity-oriented SIPs
1. LTCG Tax
As per the provisions under Section 112A of the Income Tax Act, LTCG tax is levied when your SIP investment is sold or redeemed after being held for more than 12 months. Capital gains are taxed at 12.5%, with the first Rs. 1.25 lakh exempt from taxation in that financial year. For example, if you made Rs. 3 lakh LTCG from an equity fund, you’ll only be charged tax at 12.5% on Rs. 1.75 lakh. Note that, for instance, you want to calculate tax on SIP after 15 years of holding the investment; each SIP instalment is treated as a separate investment.
2. STCG Tax
Provisions for STCG taxation on equity funds can be found under Section 111A of the Income Tax Act. If you hold your SIP investment for 1 year or less the gains are classified as STCG and are taxed at a flat rate of 20%.
The above rates were recently announced by the government during the Union Budget 2024. So if you sold your equity fund investment before 23rd July 2024, the old SIP tax rate, i.e., 10% for LTCG and 15% for STCG would be applicable.
Capital Gains Tax on Debt-oriented SIPs
Debt fund taxation has gone through significant changes in recent years, with major changes announced during Union Budget 2023 and 2024. If you invested in a debt-oriented fund after 1st April 2023, debt capital gains taxation is quite simple – All gains, irrespective of the holding period, are now taxed at your applicable income tax slab rate, with no indexation benefits. If you invested before 1st April 2023, however, taxation becomes a bit more tricky:
1. Investment sold before 23rd July 2024
- STCG tax: If the investment holding period is less than 36 months, gains are deemed short-term and taxed at your applicable income tax slab rate.
- LTCG tax: The investment must be held for more than 36 months for profits to be considered LTCG. In that case, gains are taxed at 20% with indexation benefits.
2. Investment sold after 23rd July 2024
Here, the government introduced a new rule which revised the holding period
- STCG tax: Profits are considered STCG if the investment is sold within 24 months of purchase. Gains are taxed as per the investor’s slab rate.
- LTCG tax: Gains from a debt fund investment held for more than 24 months are considered LTCG, and taxed at 12.5% without the indexation benefit.
The 24-month holding period is for unlisted securities. For listed securities, the holding period has been standardised to 12 months. An investment planner can help you understand the tax implications of different holding periods and guide you in structuring your portfolio to maximise tax efficiency. They can analyse your unique profile and make personalised recommendations on risk-mitigating strategies, tax saver SIP plans, and asset allocation for optimal returns and decreased tax liability.
TDS
Resident individuals don’t need to pay any TDS on capital gains. NRIs, however, are subject to TDS on capital gains from SIPs.
Tax Treatment of Income Distribution cum Capital Withdrawal (IDCW) from SIPs
Mutual funds with the IDCW option distribute earnings to investors at regular intervals in the form of dividends. If you invest in such a fund, you’re liable to pay tax on SIP returns. Before 2020, a dividend distribution tax was levied by the government, according to which mutual fund houses had to deduct tax before paying out dividends to investors. Since it was abolished, income from IDCW funds is taxable in the hands of investors. It is considered ‘Income from Other Sources’ and is added to their total taxable income and taxed as per their applicable tax slab rate.
TDS
Unlike capital gains, income earned from IDCW funds is subject to TDS. For resident investors, a dividend income above Rs. 5,000 attracts a TDS of 10%. The mutual fund house will deduct an SIP tax rate at 10% before crediting the income to your account. NRIs are liable to pay a higher TDS on dividends at 20%. If their DTAA benefits apply, they can be eligible for a lower TDS rate.
Tax Planning Strategies with SIPs
Here are some ways you can save taxes by investing in SIPs.
1. Invest in ELSS
Equity Linked Savings Scheme is a type of equity mutual fund known for its tax efficiency. Section 80C allows ELSS investors to deduct up to Rs. 1.5 lakh from their taxable income, which is why they are also known as tax-saving mutual funds. An investor in the 30% slab can thus save up to Rs. 46,800 per year by investing in ELSS.
Among the 80C tax free investments in India such as the PPF, SSCS, and NPS, ELSS funds have the shortest lock-in period of 3 years. Since this fund invests heavily in equities, investing in an ELSS SIP plan for 5 years or more would likely yield better returns.
2. Growth option vs IDCW option
Funds with the growth option reinvest their earnings which results in an increased NAV. Since these funds don’t pay out dividends, income earned from them can only be taxed as capital gains.
On the other hand, IDCW funds regularly distribute income to their investors which results in the NAV going down after every payout. Not only are capital gains taxes levied upon redemption, but also the income earned as dividends taxed at applicable slab rates. For investors in the higher tax brackets, the liability from such funds could be significant. If you don’t need a regular income and want to invest for the long term, growth funds will likely provide you with favourable taxation.
3. Lower LTCG tax on equity funds
Investing in equity funds for the long term yields better post-tax returns due to the lower tax rate.
4. Take advantage of the LTCG exemption
In a financial year, up to Rs. 1.25 lakh LTCG earned from equity investments is exempt from taxes. Withdrawing investments systematically can help investors take advantage of this exemption and minimise their tax liability.
5. Consult an expert
You can’t go wrong by taking advice from a professional SIP investment planner. With an expert by your side, not only can you save more of your hard-earned money but also work effectively towards realising your financial dreams through personalised financial planning.
What are the SIP Tax Benefits?
By investing in ELSS tax saver SIP plans, you can enjoy a tax deduction of up to Rs. 1.5 lakh in a financial year. Since these are equity funds with a three-year lock-in, only LTCG tax can be levied on them upon redemption. You can enjoy lower tax rates and benefit from the LTCG tax exemption that comes with it. A smart withdrawal strategy can make an equity SIP investment plan even more efficient in the long run.
When is the Right Time to Start Investing in a SIP?
You should ideally start investing in an SIP as soon as possible. This is because SIPs benefit from compounding interest, which Einstein once called the ‘eighth wonder of the world’. When your returns get reinvested they earn their own returns which has an exponential effect. Check out this example to understand the magic of compounding:
If you invest Rs. 5,000 per month in an equity fund with a 12% expected rate of return, in 15 years your total investment value of Rs. 9 lakh will grow to Rs. 25 lakh. Suppose you decide to stay invested for 5 more years (a total of 20 years), the value of your Rs. 12 lakh investment will grow to almost Rs. 50 lakh! As you can see, the longer you stay invested, the more your wealth multiplies.
Another reason why you don’t need to wait before starting an SIP is rupee cost averaging. With lump sum investments, you need to be mindful of when you should enter the market. With SIPs, that’s not the case. Rupee cost averaging makes sure that you buy more units when prices are low and fewer units when prices are high, which helps average out the cost of your investment.
Even tax-wise, early planning can be advantageous as you won’t scramble for last-minute investments in tax saving SIP to save taxes. Rushing to invest in tax-saving instruments like ELSS at the end of the financial year may save some tax on SIP returns, but investing in them without proper research can lead to choices that may not align with your financial goals and risk tolerance.
Conclusion
SIP taxation boils down to the type of income (capital gains vs dividends), category of fund (equity vs debt), and the holding period of the investment (LTCG tax vs STCG tax). Investing in growth-oriented equity funds such as an ELSS tax saving SIP can help you maximise your savings. If you hope to save as much tax on SIP investments as possible, call our experts today! Our experienced advisors will guide you on your investment journey by creating a personalized plan tailored to your financial goals, risk appetite, and situation, ensuring you don’t pay any more taxes than needed.
Frequently Asked Questions (FAQ)
1. Is SIP investment tax-free?
No, investing in SIP attracts tax on capital gains and dividends. Capital gains tax is only paid when the SIP investment is sold or redeemed, whereas income from dividends is taxed every financial year according to the investor’s tax slab. There are ways to save tax on SIP investments, for example, long-term capital gains from equity and equity-oriented hybrid funds up to Rs. 1.25 lakh are exempt from taxation. Moreover, an investment in ELSS SIP can help you reduce your taxable income by Rs. 1.5 lakh under Section 80C.
2. How is SIP income taxed?
SIPs are taxed based on the type of income earned (capital gains and dividends), type of fund (equity or debt), and holding period of the investment (LTCG and STCG).
- Income from dividends is added to your taxable income and taxed as per your slab rate.
- Gains from debt mutual fund investments made after 1st April 2023 are also added to the investor’s taxable income and taxed at the applicable rate.
- LTCG tax on equity funds is levied at a rate of 12.5% on gains of more than Rs. 1.25 lakh in a financial year.
- STCG tax on equities is applied at 20% on gains made when the investment is redeemed within a year of purchase.
3. What is the tax on SIP returns?
Dividend income from mutual funds falls under the head ‘Income from Other Sources’ and is taxed according to your slab rate. Here’s how SIP income tax on gains works on debt and equity funds:
Debt Funds: Gains from SIP investments made after 1st April 2023 are taxed according to your slab rate. For investments made before that date, there are two scenarios:
- Sold before 23rd July 2024: Investments held for more than 36 months are taxed at 20% with indexation benefits, and less than 36 months are taxed as per the income tax slab.
- Sold after 23rd July 2024: Profits from investments held for less than 24 months attract STCG which is taxed according to slab rates. LTCG tax of 12.5% is applicable if the investment is sold after being held for 24 months.
- Equity Funds: If the investment is sold within 12 months, an STCG tax is levied at 20%. Investment held for more than 12 months attracts a lower LTCG tax at 12.5% on gains in excess of Rs. 1.25 lakh.
4. Are tax-saving SIPs effective?
Yes! A tax saving SIP made in an Equity Linked Savings Scheme can help you deduct up to Rs. 1.5 lakh from your taxable income in a financial year. Moreover, when you redeem your ELSS investment, LTCG tax is charged at a lower rate of 12.5% in excess of Rs. 1.25 lakh. Making smart withdrawals can help you optimize your tax liability and ensure that you keep more of your investment gains. And since these invest mainly in equities, they are considered excellent long-term tools for wealth creation.
