Beginner

Amended as on Apr 1, 2023: Please note that as per amendments in Finance Bill 2023, from April 1, 2023, profits made on investments in debt mutual funds are now taxed as short-term capital gains if these funds invest <=35% in equities. This means, debt mutual funds are now taxed as per the income tax rates as per an individual’s income.

Also note that with effect from Apr 1, 2020, Dividend Distribution Tax (DDT) was abolished, and mutual fund dividends were made taxable in the hands of investors. Dividend income is now considered as ‘income from other sources’ and investors need to pay tax on it as per their individual tax slabs.

This article is currently in the process of getting updated, as it was originally written at a time when tax rules were different. Please treat this note as the latest updated tax information in the meanwhile.

Neha, 25 years old and a software programmer, makes her first investment in a mutual fund. She chooses a well-performing debt fund which is rated as a good investment by several investment-advisory websites. She is proud of having taken the first step in her journey towards wealth accumulation. She has heard that mutual funds once charged an ‘entry load’ when an investor made an investment in a fund. So, if the fund’s units were available at a net asset value (NAV) of Rs 10, with a 1% entry load, the investor paid Rs 10.10 per unit (NAV of Rs 10 + entry load of 1% of Rs 10). Fortunately, mutual funds no longer charge an entry load. Neha is glad to hear about this.

About three months later, in her hurry to take an important call, Neha drops her cell phone. She is in for a nasty shock. Her cell phone, which fell on a stone on the pavement, is damaged beyond repair. Like most of us, Neha can’t do without a cell phone. However, she is a spendthrift and on that particular month, she barely has enough money to see her through till her next salary cheque hits her bank account. In desperation, Neha decides to redeem her debt fund investment. She quickly checks the current NAV of the scheme; it is Rs 42. She made her investment at an NAV of Rs 40. She goes ahead and submits a redemption request. Because she holds 500 units, she expects Rs 21,000 (current NAV of Rs 42 x 500 units) to be credited by the mutual fund into her bank account, but she is surprised to find that Rs 20,895 has been credited into her account. On checking with the mutual fund about this ‘discrepancy’, she is told that she has been charged an ‘exit load’ of 0.5% on her redemption. She does a quick calculation (NAV of Rs 42 – exit load of 0.5% of Rs 42, i.e. 0.21 = 41.79 per unit x 500 units). She finds the answer to be Rs 20,895, which has been received into her bank account. On making further enquiries, she is informed that because she exited the debt fund within six months of her investment in it, the exit load has been levied.

So what is an exit load?

An exit load is levied by a mutual fund if you redeem your investment within a stipulated time period. The exit load is charged to discourage investors from redeeming their investment too early, giving their investment ample time to work for them.

Mutual funds charge an exit load of anywhere, generally between 0.5% and 2% of the NAV (the highlighted tax is not from tax point of view). The exit load varies depending on the type of scheme and investment tenure. The exit load is deducted from the NAV. For example, if the NAV at the time of redemption is Rs 10 and the fund levies an exit load of 1%, the investor will receive his redemption amount at the rate of Rs 9.90 per unit (i.e. NAV of Rs 10 minus exit load of 10 paise (1% of Rs 10)).

Concurrent impact on taxes

Where equity funds are concerned, exiting early has a dual adverse effect: When you exit from an equity funds in less than one year, not only are you charged an exit load but you also pay taxes on your capital gains. For instance, let’s say you hold 500 units of an equity fund which you purchase at Rs 10 per unit and sell within a year at Rs 50 per unit. If the mutual fund levies an exit load of 1% due to early redemption, you will receive Rs 49.5 per unit (NAV of Rs 50 – exit load of 1% on Rs 50). So, you will incur a capital gain of Rs 19,750 (redemption value of Rs 24,750 (Rs 49.5 per unit x 500 units) – cost (Rs 10 per unit x 500 units)). You will pay tax at the rate of 15.60% (15% capital gains tax +4% Health and Education Cess, assuming the income is below 50 lakhs and surcharge is not applicable)

Note: Surcharge @10% is applicable if income is between 50 lakhs to 1 crores, and @ 15% for income greater than 1 crores for Individuals/HUFs/BOIs/AOPs and Artificial juridical persons, surcharge rate is different for other tax classes) on the gain.

In other words, your tax outgo will be about Rs 3,081 (Rs 19,750 x 15.60%) and you will be left with Rs 16,669 of gains after the exit load and taxes.

On the other hand, if you exit an equity fund after a year, as per the Finance Bill, 2018, it has been proposed that any capital gain exceeding INR one lakh for a financial year shall be taxable at the rate of 10% plus applicable surcharge and health and education cess.

This is somewhat similar to the case of debt funds. If you exit early (i.e. before three years), your gains will be added to your other income and taxed as per applicable slab rates. This will be over and above any exit loads that the fund charges. However, if you exit after three years, you will get the benefit of a lower tax rate of 20% after taking the benefit of indexation. Indexation refers to the indexing cost basis of the prevalent inflation as referenced in the Cost Inflation Index table published by the government, which helps inflate your cost of investment after considering inflation. This results in reducing your capital gains and, hence, your capital gains tax.

Exit load on SIPs and STPs

A systematic investment plan (SIP) is an investment strategy where you invest a fixed sum every week/month/quarter into a mutual fund scheme.

A systematic transfer plan (STP) is an investment strategy where every week/month/quarter you invest a lump sum or invest via an SIP in a scheme (usually a debt or liquid fund) called the source fund and transfer a fixed amount from this scheme into another scheme (usually an equity fund) called the target fund.

Both SIPs and STPs are undertaken to invest regularly in equity, which results in averaging down the cost of investment.

In the case of an SIP, the concept of ‘first in, first out’ is followed. This means that the earliest SIP investment is assumed to have been redeemed first. The investment period is taken from the investment date of the SIP to the date of redemption. Let’s understand this with an example:

Say you have made SIP investments of Rs 1,000 per SIP in a mutual fund scheme on the following dates:

Now, say you redeem 80 units on 25 February 2017; it is assumed that you have redeemed these units from the units you received on 1 January. This means the holding period is considered to be 56 days (31 days of January and 25 days of February). If the mutual fund levies an exit load of 1% in the case of redemption before three months (90 days), this load will apply to you since you are redeeming before 90 days. Hence, if the NAV on 25 February 2017 is Rs 11, you will receive Rs 10.89 per unit (Rs 11 minus 1% of Rs 11 (i.e. Re 0.11 per unit), the exit load cost you have to bear). However, if you redeem these units after 90 days (anytime after 31 March 2017), you will not be charged any exit load. If the NAV is Rs 15 at the time of redemption, you get the full value of Rs 1,200 (i.e. 80 units x Rs 15 per unit).

In the case of an STP investment, you may have to pay an exit load on the STP from the source fund; you may also need to pay an exit load if you redeem early from the target fund. Here, too, the concept of ‘first in, first out’ is applied. For example, if you have made an SIP into a debt fund from which you do an STP into an equity fund, the first STP into the equity fund is considered to be from the first SIP you have made into the debt fund. Here is an example to explain this:

Let’s say you have made SIP investments of Rs 1,000 per SIP in a debt fund on the following dates:

Now when you do an STP into an equity fund, the amounts/units redeemed in the debt fund are taken on a ‘first in, first out’ basis to see if the exit load applies. For instance, for an STP of Rs 1,000, the first STP will be assumed to have been done by redeeming units received on 1 January 2017. If the debt fund levies an exit load for redemption within three months and the STP is done on 1 March 2017, an exit load will be levied on the redemption.

To conclude, investing should be made for the long term to help you build a meaningful amount of wealth. Investing for the long term not only reduces your investment risk, but it also helps you grow your wealth.