The Union Budget 2024, presented by Finance Minister Nirmala Sitharaman, has introduced significant changes to the taxation of mutual funds, affecting the way Systematic Investment Plans (SIPs) and their returns will be taxed. The hike in both Short-Term Capital Gains (STCG) and Long-Term Capital Gains (LTCG) tax rates on equity-oriented funds is set to have a notable impact on investors.
Key tax changes announced
- STCG Tax Rate Increased:
The tax rate on STCG for equity mutual funds has been increased from 15% to 20%. This will impact investors who redeem their investments within one year of purchase. - LTCG Tax Rate Hike and Exemption Limit:
The LTCG tax rate for equity funds has been raised from 10% to 12.5%. However, the exemption limit for LTCG tax has been increased from ₹1 lakh to ₹1.25 lakh per financial year. - Introduction of Section 50AA:
Mutual funds with over 65% investment in debt or money market instruments will fall under Section 50AA, making them ineligible for benefits accorded to specified mutual funds. Notably, this includes Exchange-Traded Funds (ETFs), Gold Mutual Funds, and Gold ETFs.
Impact on SIP investors
For SIP investors, each instalment is treated as a separate investment for tax purposes. This means the holding period and applicable tax rate will be calculated individually for each contribution.
Short-term investors
For those redeeming investments in less than a year, the increase in STCG tax to 20% will result in higher outflows. For instance, an investor redeeming a substantial SIP investment shortly after making it will now face a heavier tax burden.
Long-term investors
Investors who hold equity mutual funds for over one year will see an increase in LTCG tax. For example, a ₹50,000 SIP invested over five years could now incur a capital gains tax of ₹94,095, compared to ₹77,456 under the previous tax regime. However, the increased exemption limit provides some relief to small investors, as gains up to ₹1.25 lakh annually will remain tax-free.
Illustrating the impact
Let’s take an example of an SIP investor contributing ₹20,000 per month:
- Scenario 1: Short-Term Redemption
If the investor redeems their entire holding within a year, the gains will be taxed at 20%, increasing their tax liability compared to the previous 15% rate. - Scenario 2: Long-Term Redemption
If the investment is held for over a year, LTCG tax applies. The increase to 12.5% from 10% will result in higher taxes for large investors. However, small investors with annual gains under ₹1.25 lakh will benefit from the increased exemption.
Effect on mutual fund categories
Mutual funds investing heavily in debt and money market instruments, such as Gold Mutual Funds and ETFs, will now fall under Section 50AA. These funds will no longer enjoy the tax benefits previously available to specified mutual funds, potentially affecting their attractiveness to investors seeking tax efficiency.
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What should investors do?
Reassess Investment Strategies
Investors should revisit their portfolio strategies in light of these tax changes. Equity fund investors may need to account for higher tax outflows when calculating expected returns.
Focus on long-term investments
Despite the higher LTCG tax, long-term investments remain more tax-efficient than short-term investments. The increased exemption limit offers additional relief for small investors.
Diversify across asset classes
With changes to the treatment of debt and money market funds, investors should consider diversifying across asset classes, such as direct equities, gold, and other tax-efficient instruments.
The Budget 2024’s changes to capital gains taxation reflect a shift towards increased government revenue from mutual fund investments, particularly equity-oriented funds. While the higher tax rates may pose challenges for short-term and high-net-worth investors, the increased LTCG exemption limit provides some relief to smaller investors.
As SIPs remain a popular mode of investment for wealth creation, investors must now approach their strategies with greater attention to tax implications, ensuring their financial goals align with the new tax landscape.
