Although, broadly mutual funds and equities are structured similarly, there is one major difference - In equity trading all the transactions are subject to capital gains tax, as against mutual funds wherein the underlying transactions are not taxed. One also needs to keep in mind that debt mutual funds are taxed differently.

Tax implications depend on the option one has chosen - growth or dividend payout/re-investment.

The returns are generated by means of capital appreciation. The NAV would fluctuate based on market trends and this would determine the profit / loss of the underlying mutual fund. This is treated as capital gains.

Equity Mutual Funds:

If the units have been held for a period less than 12 Months and redeemed, then they are assessed as ``Short Term Capital Gains`` and are taxed at 15% + surcharge/cess (as applicable). If the redemption is done after a period of 12 Months, then they are assessed as `Long Term Capital Gains` and the tax implication is `Nil`.

Debt Funds and funds with less than 65% exposure in Indian equity shares are treated differently. In case of long term the tax applicable is 10% without indexation or 20% with indexation (indexation is inflation being adjusted to purchase cost). Short term gains are added to income and taxed at normal rates.

Dividend Option (Payout & Re-investment)

Dividend provides regular income; this is declared as a % of face value of the scheme. Payout option implies that the amount so declared are pad out. In case of re-investment, the amount declared as dividend is used to buy additional units of the same scheme (as on the record date).

As per the current tax laws, dividend declared by equity and equity oriented funds is tax free in the hands of investors.

However, there is a dividend distribution tax is applicable on non equity funds and is paid by the mutual fund house directly. This would have a compensating impact on the funds. Liquid and money market funds attracting 28.32%, other non equity funds attract 14.16% as DDT for individuals.

Suitability Analysis
Growth option can be used especially for investments in both equity and non equity funds for long term investment. Especially for debt funds, the option of indexation can help reduce the taxation significantly.

Dividend option suits non equity funds, especially in the short term. There can be a substantial tax benefit by doing so.

Summary of Tax Benefits

It is important to plan your investments in line with taxation. The differential return can be significantly higher.

Anil Rego is the founder and CEO of Right Horizons, an Investment Advisory and Wealth Management Company. Right Horizons has successfully practiced a de-risked model with a Contrarian approach.