Here's how your gains from systematic investment plan will be taxed

Mutual funds can be an ideal investment option for wealth creation especially with the Systematic Investment Plan (SIP). While creating an investment portfolio, you tend to overlook the tax component which would be applied to your investment options. Here we guide you on what tax would be applicable to your SIP investment in mutual funds.

What is capital gains, how it is calculated?

You invest in mutual funds according to your time and requirements and whatever you earn from your invested amount is called Capital Gain. Capital gain is simply the difference between the investment amount and the sale price of investment. Depending on the holding period, capital gains can be classified as short-term capital gains (STCG) and long-term capital gains (LTCG).

Long Term Capital Gains (LTCG): Exempting the gain of 1 lakh, LTCG is 10% for equity mutual funds and 20% with indexation debt mutual funds above 1 lakh gain. LTCG on equity mutual fund does not get the benefit of indexation. In mutual funds, indexation is a way to adjust your capital gains as per the prevailing inflation index. This helps to lower your overall liability to pay taxes. LTCG applies to debt funds for a holding period of more than 3 years and to equity mutual funds for a holding period of more than 1 year.

Short term Capital Gains (STCG): Short term gains attract a higher tax rate as compared to long term gains. In the case of equity funds, STCG is taxed at a rate of 15%.  But, the rates of taxation for debt funds differ altogether. Short term gains are taxable at your individual income tax slab rates.  Holding period of fewer than 12 months for equity mutual funds and less than 36 months for debt mutual funds are considered as short term.

While both SIP and lump sum investments made in a scheme are taxed at the same rate, the tax calculation is a bit more elaborate in the case of SIP.

How is SIP taxation different?

Unlike lump-sum investments where there is a single investment, SIP investments are made over multiple dates. While we may think of a one-year SIP as one investment. For tax purposes, each instalment is considered a fresh investment. Accordingly, the holding period for each instalment is calculated.

For e.g. A monthly SIP started on January 1, 2020, the entire investment is redeemed on January 2, 2021. In this case, only capital gains on the units purchased from the first instalment (invested on January 1, 2020) will get the benefit of be long-term capital gains as that is the only one held for more than a year. For the remaining units, the holding period is lower than one year. Hence, the gains will be taxed at short-term rates.

The first in first out rule is followed for determining how long the units were held. First in first out means that the units bought first will be redeemed first. In simple terms tax on the total SIP, investment is the sum of tax payable on each instalment. To calculate the tax on the SIP we need to individually calculate tax on each instalment.