Devika Patil (an illustrative profile) is 50, runs a small printing business in Pune and is in the 30% tax slab. She wants to redeem ₹10 lakh from an equity fund held for four years for her son's college fees, run an STP of a ₹12 lakh bonus into equity, and decide whether her ₹5 lakh emergency money should sit in a debt fund or an FD. Her retired aunt calls her monthly IDCW payout a "pension". And Devika has heard that "mutual funds are tax-free after a year", which is true only for some funds, and only up to a limit.
This chapter covers the tax mechanics specific to mutual funds, for resident individuals in FY 2026-27, with a worked example for each of Devika's decisions.
In this chapter
- Which tax bucket a fund falls into, and why the portfolio, not the name, decides it
- How FIFO works on SIP redemptions, and how to size a redemption to save tax
- IDCW versus growth with a SWP, compared in rupees
- Why STPs and SWPs are taxable redemptions, and what that means in practice
Three tax buckets, decided by the portfolio
Mutual funds can give you two kinds of income. Capital gains arise when you redeem or switch units for more than you paid. Dividends, officially called Income Distribution cum Capital Withdrawal (IDCW), arise only if you choose an IDCW option instead of growth. For capital gains, what matters is the fund's tax bucket and how long you held each unit. The rates below apply for FY 2026-27 under the Income-tax Act, 2025.
| Tax bucket | Long-term after | Long-term tax | Short-term tax |
|---|---|---|---|
| Equity-oriented (at least 65% in Indian equity) | 12 months | 12.5% on gains above ₹1.25 lakh a year | 20% |
| Specified (debt) funds bought on or after 1 April 2023 | No long-term status | Slab rate | Slab rate |
| Other non-equity funds | 24 months (12 months for listed units such as ETFs) | 12.5%, no indexation | Slab rate |
The bucket depends on what the scheme actually holds, so similar-sounding funds can be taxed very differently.
| Category | Usual tax bucket |
|---|---|
| Large, mid, small, flexi cap, ELSS, Indian index funds | Equity-oriented |
| Arbitrage, aggressive hybrid, many balanced advantage funds | Equity-oriented (hedged equity counts) |
| Liquid, overnight, money market, gilt, corporate bond, conservative hybrid | Specified (slab rate) |
| Balanced hybrid, many multi-asset funds (35–65% equity) | Other non-equity |
| Gold and silver ETFs; gold and international funds of funds | Other non-equity |
The ₹1.25 lakh exemption is one annual limit per person, shared across equity-oriented funds and listed shares. How these rates compare with property, gold and unlisted shares is set out in capital gains across assets.
Worked examples: a lump-sum redemption and a SIP
Example 1: Devika's college-fee redemption. She redeems units worth ₹10 lakh that cost ₹6 lakh, all held for four years, with no other equity gains this year.
- Long-term gain = ₹10 lakh − ₹6 lakh = ₹4 lakh.
- Taxable gain after the ₹1.25 lakh exemption = ₹2.75 lakh.
- Tax at 12.5% = ₹34,375; with 4% cess, ₹35,750.
- Had the units been under 12 months old, the full ₹4 lakh would be taxed at 20%: ₹83,200 with cess.
Example 2: FIFO on a SIP. Each SIP instalment is a separate purchase with its own 12-month clock, and units are redeemed first-in, first-out (FIFO), meaning the oldest go first. Devika has run a ₹10,000 monthly SIP for 18 months. Inputs (illustrative): months 1–6 bought 1,500 units at an average NAV of ₹40; months 7–12 bought about 1,333 units at ₹45; months 13–18 bought 1,200 units at ₹50. Today's NAV is ₹55, and only the first six instalments are over 12 months old.
- If she redeems 2,000 units (₹1.1 lakh): FIFO takes all 1,500 oldest units, a long-term gain of 1,500 × ₹15 = ₹22,500, within the exemption.
- The other 500 units come from months 7–12, a short-term gain of 500 × ₹10 = ₹5,000, taxed at 20%: ₹1,040 with cess.
- If she redeems only 1,500 units (₹82,500): every unit is long-term and the gain is exempt, so tax is nil.
Your capital gains statement lists each lot; redeeming by amount without checking can quietly reach into short-term lots.
Debt funds versus FDs: what deferral is really worth
Gains on debt funds bought on or after 1 April 2023 are taxed at slab rate, like FD interest. The only difference is timing: FD interest is taxed yearly as it accrues; a debt fund's gain only on redemption.
Example 3: Devika's ₹5 lakh emergency money. Assume both earn 7% a year for three years (the fund's return is not fixed and is shown after costs), at a 30% slab plus cess (31.2%).
- FD: tax is paid on each year's interest, so it compounds at about 7% × (1 − 0.312) = 4.82% after tax. After three years: about ₹5,75,800.
- Debt fund: grows untaxed to ₹5 lakh × 1.07³ = about ₹6,12,500, a gain of ₹1,12,500.
- Tax on redemption at 31.2% = about ₹35,100, leaving about ₹5,77,400.
- Difference: about ₹1,600 over three years. Real, but small.
So the case for a debt fund rests on liquidity and partial withdrawals, weighed against a return that can vary. Tax alone is no longer a strong reason.
IDCW versus growth with a SWP
IDCW is added to your income and taxed at slab rate, and the fund deducts 10% TDS once IDCW from that fund house crosses ₹10,000 in the year. IDCW is paid out of the fund's own assets, so the NAV falls by the amount paid. A Systematic Withdrawal Plan (SWP) from the growth option redeems units instead, and only the gain inside each withdrawal is taxed.
Example 4: ₹60,000 a year two ways. Inputs (illustrative): an equity-oriented fund, 30% slab, units held over 12 months, NAV ₹50 against an average cost of ₹40, no other equity gains.
| IDCW payout of ₹60,000 | SWP of ₹60,000 from growth | |
|---|---|---|
| What is taxable | The whole ₹60,000, at slab | Gain portion: 1,200 units × ₹10 = ₹12,000 |
| Rate | 30% plus cess | Long-term, within the ₹1.25 lakh exemption |
| Tax for the year | ₹18,720 | Nil |
| TDS | ₹6,000 deducted | None for resident individuals |
The gap narrows in the nil or 5% slab, and IDCW amounts can vary or stop. In higher slabs, growth plus a SWP is usually the more tax-efficient way to draw income.
STPs and switches are redemptions too
A Systematic Transfer Plan (STP) moves money from one scheme to another in instalments. Each transfer redeems units of the source fund, so it is a taxable event. Example 5: Devika parks ₹12 lakh in a liquid fund earning an assumed 6.5% and transfers ₹1 lakh a month into an equity fund. Across the 12 transfers, about ₹40,000 of gains are realised in the liquid fund, all taxed at her slab: roughly ₹12,500. Each equity instalment then starts its own 12-month clock. A switch between schemes, or from regular to direct, is likewise a redemption followed by a purchase.
Gains and losses from all these redemptions can be offset against each other within limits: a short-term loss can reduce short-term or long-term gains, a long-term loss only long-term gains, and unused losses carry forward for eight years if you file on time. Set-off order and yearly gains harvesting are explained, with the arithmetic, in tax-harvesting, set-off and carry-forward.
Common mistakes to avoid
- Assuming a fund's name tells you its tax bucket. A "hybrid" or "multi-asset" fund may be taxed as equity, debt or neither.
- Redeeming by amount without checking unit ages. FIFO can pull in short-term units taxed at 20%.
- Treating a switch or STP as tax-neutral. Each one is a redemption with its own gain.
- Choosing IDCW for "regular income" in a high slab. The whole payout is taxed, while a SWP taxes only the gain.
- Picking a debt fund over an FD purely for tax. Since April 2023 the advantage is only deferral.
Try this yourself: Download your capital gains statement and your consolidated account statement. For your largest equity fund, list each purchase lot with its date and find how many units are already over 12 months old. Multiply by today's NAV: that is the most you can redeem without touching short-term units. Then check each fund's category against the bucket table above.
Frequently asked questions
Is SIP income tax-free after one year?
No. For equity-oriented funds, each instalment becomes long-term only 12 months after its own purchase date, and long-term gains up to ₹1.25 lakh a year in total are exempt. Gains beyond that are taxed at 12.5%, and instalments held less than 12 months are taxed at 20% if redeemed.
Are debt mutual funds still better than fixed deposits for tax?
For units bought on or after 1 April 2023, both are taxed at your slab rate. The remaining advantage is deferral, since tax is due only on redemption, and it is usually modest. Liquidity and flexibility matter more.
Is TDS deducted when I redeem mutual funds?
For resident individuals, no TDS is deducted on capital gains from redemptions, STPs or SWPs; you pay any tax through advance tax or your return. TDS of 10% applies to IDCW above ₹10,000 a year from a fund house. Different rules apply to NRIs.
How is a gold ETF taxed?
As a listed non-equity fund, a gold ETF becomes long-term after 12 months and long-term gains are taxed at 12.5% without indexation. A gold fund of funds needs 24 months for long-term status. Short-term gains on both are taxed at your slab rate.
Rules have changed several times since 2023, so check them before large redemptions. Related: tax-aware withdrawal strategies, and next, choosing and reviewing funds.