Most investors check a fund’s past returns and ignore the tax bill that follows. That bill can take a real bite out of your profit, and it varies widely by fund type. Two investors who each earn ₹1 lakh can walk away with very different amounts depending on whether they held an equity fund or a debt fund, and for how long.
This guide explains how the Income-tax Department treats each major fund category, with worked examples you can adapt to your own portfolio. It uses the familiar section numbers from the Income-tax Act, 1961, which fund statements and tax advisers still cite. The Income-tax Act, 2025 took over from April 1, 2026 and renumbered many sections, but the rates below carry over.
Two Ways Mutual Funds Create Tax
You owe tax in two situations:
- You redeem or switch units at a profit. The tax treats this as a capital gain.
- The fund pays you income. This covers dividends under the IDCW (Income Distribution cum Capital Withdrawal) option.
Everything else, including a rising NAV, creates no tax until you redeem.
Equity-Oriented Funds
A fund qualifies as equity-oriented when it keeps at least 65% of its portfolio in domestic equity shares. Pure equity funds, index funds, ELSS, arbitrage funds and most equity-heavy hybrid funds all meet this test.
- Short-term capital gains (units held 12 months or less):Â 20% under Section 111A.
- Long-term capital gains (units held more than 12 months): 12.5% under Section 112A, but only on total annual gains above ₹1.25 lakh.
Add 4% cess to both rates. Surcharge may apply on higher incomes, and it stays capped at 15% on these gains.
Example 1: You redeem units after nine months and book ₹80,000 in profit. You pay ₹16,000 in tax plus ₹640 in cess, a total of ₹16,640.
Example 2: You sell units held for three years and book ₹2 lakh in long-term gains during the year. The first ₹1.25 lakh escapes tax. You pay 12.5% on the remaining ₹75,000, which comes to ₹9,375, plus ₹375 in cess.
Debt Funds and Section 50AA
Debt funds carry the most confusing rules. Section 50AA covers “specified mutual funds,” and from April 1, 2026 that label applies to any fund investing more than 65% of its money in debt and money-market instruments. It also covers funds that put 65% or more into units of such funds.
If you bought units of a specified fund on or after April 1, 2023, the law treats every gain as short-term, whether you held for six months or ten years. You then pay tax at your income-tax slab rate. Indexation no longer exists, and neither does a long-term rate.
Example 3: You sit in the 30% bracket and redeem a liquid fund with a ₹1 lakh gain. Your tax comes to ₹30,000 plus ₹1,200 in cess. Holding longer would not have reduced it.
For investors in higher brackets, this makes debt funds far less tax-efficient than they were before 2023. Compare the post-tax yield against bank fixed deposits before you choose.
Other Funds Worth Knowing
Funds outside both categories above follow the general capital-asset rules. This group includes international funds of funds, gold funds and equity-light hybrids.
- If you hold these units for more than 24 months, the gain counts as long-term and carries a 12.5% rate without indexation.
- If you sell earlier, the gain counts as short-term and follows your slab rate.
Fund houses classify their schemes differently, so read the scheme document to see which bucket your fund falls into. Dynamic asset allocation funds, for example, sometimes qualify as equity-oriented and sometimes do not.
Quick Reference
| Fund type | Long-term threshold | Short-term tax | Long-term tax |
|---|---|---|---|
| Equity-oriented | Over 12 months | 20% | 12.5% above ₹1.25 lakh |
| Specified (debt) funds | None | Slab rate | Slab rate |
| Other non-equity funds | Over 24 months | Slab rate | 12.5%, no indexation |
Dividends (IDCW)
Fund houses no longer pay tax on your behalf. You add the IDCW you receive to your total income and pay tax at your slab rate. If a fund house pays you more than ₹10,000 in a financial year, it deducts 10% TDS before it credits the money. TDS does not settle your liability; you still report the full amount in your return and claim credit for the tax already deducted.
Because IDCW carries slab-rate tax and the growth option defers tax until redemption, most long-term investors in higher brackets prefer the growth option.
How SIPs and Switches Work
A SIP does not create its own tax category. Every instalment counts as a separate purchase with its own holding period. When you redeem, the fund follows the first-in, first-out method: it sells your oldest units first. If you started a SIP 18 months ago, a partial redemption today mostly uses long-term units.
A switch between schemes, even inside the same fund house, counts as a redemption followed by a fresh purchase. You owe tax on any gain at the time of the switch. Moving from an equity fund to a hybrid fund can therefore cost you money that a plain hold would not.
Working Out Your Gain
Your gain equals the sale value minus your purchase cost. You can also subtract exit load and other direct transfer expenses. Securities Transaction Tax does not qualify as a deduction.
If you bought equity units before February 1, 2018, the law lets you use the higher of your actual cost or the fair market value on January 31, 2018, capped at your sale price. This grandfathering rule protects the gains you built up before long-term gains became taxable.
Setting Off Losses
You can use a loss to cut your tax bill in the following ways:
- Short-term losses offset both short-term and long-term gains.
- Long-term losses offset only long-term gains.
- You can carry unused losses forward for eight assessment years.
You lose the carry-forward benefit if you file your return after the due date, so file on time even when you owe nothing.
Four Steps to Lower Your Bill
- Use the ₹1.25 lakh exemption every year. Sell equity units with long-term gains up to the limit, then buy them back. The exemption resets each April and does not carry forward, and the repurchase raises your cost base.
- Check your holding period before you redeem. Waiting a few extra days to cross the 12-month line cuts the rate from 20% to 12.5%, with an exemption on top.
- Use your unused basic exemption. Resident individuals whose other income falls below the basic exemption limit can apply the unused portion against short-term gains under Section 111A and long-term gains under Section 112A.
- Stagger large redemptions. Splitting a big withdrawal across two financial years lets you claim the ₹1.25 lakh exemption twice.
Reporting Requirements
Download your capital gains statement from CAMS or KFintech, or from your platform, and match it against your Annual Information Statement. Report every sale in Schedule CG of your return, even when your gains stay below the exemption limit or TDS covered them.
Final Word
Fund selection and tax planning belong together. Equity funds reward patient holders with a lower long-term rate and a generous annual exemption. Debt funds offer no such reward, so judge them on post-tax yield alone. Tax rules change with almost every Union Budget, so verify the current rates before you redeem a large holding, and consult a chartered accountant for anything specific to your situation.
This article gives general information, not tax or investment advice.
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