How are ETFs Taxed?

Know how returns from ETFs are taxed. Read to explore ETF taxation, ETF tax rates and more in detail.
How are ETFs Taxed?
3 mins read
12-Apr-2024

Exchange-traded Funds (ETFs) combine the best features of stocks and mutual funds. ETFs, like mutual funds, invest in a basket of stocks, bonds or other securities and assets. Additionally, like stocks, ETFs can be traded on stock exchanges. So, they give you a unique combination of diversification and liquidity. That said, how does ETF taxation work?

Before you add any new asset to your portfolio, you need to be aware of the different types of returns you can earn from this investment. You must also know how those returns are taxed. So, in this article, let us explore ETF taxation, ETF tax rates and more.

Different types of returns offered by ETFs

Depending on the type of ETFs you invest in, you can earn income in any one of or both the following ways.

  • Income from ETF dividends
    Exchange-traded funds invest in a wide range of securities including stocks. The dividends received from these equity investments may be paid out to investors either in cash or reinvested in the fund in the form of additional ETF units.
    If you have invested in dividend option of the fund and receive the dividend income from the ETFs, you need to include it in your total income when you are computing your tax liabilities for the year. Such dividends from ETFs are classified under the category of ‘other income.’
  • Capital gains
    This is another way in which you can benefit from your ETF investments. If you redeem your ETF holdings at a higher price than the cost you incurred to purchase them, you effectively earn capital gains from this transaction.
    Such gains are only possible if the value of the ETFs appreciates over time. The rate of ETF capital gains tax depends on the period over which you held your ETF investments and on the type of exchange-traded fund.

How different incomes from ETFs are taxed?

The nuances of ETF taxation depend on the type of income you earned from your ETF investments — which could be dividends, capital gains or both. Let us look at the ETF tax rates on each of these types of income.

1. Taxation of dividend income from ETFs

The dividend income earned from exchange-traded funds is classified as ‘income from other sources’ and added to your total income. Consequently, it is taxed at the income tax slab rate applicable to you.
For instance, say you earn Rs. 5,000 as a dividend from your ETF holdings in FY23. Now, suppose that your total income comes out to be Rs. 5,00,000. The dividend from ETFs is added to this income, taking your total taxable income to Rs. 5,05,000. The appropriate tax rate (depending on whether you choose the new tax regime or the old one) will be applied to this value to arrive at your tax liability.

2. Taxation of capital gains from ETFs

The rates of the ETF capital gains tax are different depending on whether you earned short-term or long-term profits. The type of ETF also influences the rate of tax, as outlined below.

  • Capital gains from equity ETFs
    If the ETFs were held for less than 1 year, the profits are considered to be short-term capital gains. Such gains are taxed at 15% u/s 111A of the Income Tax Act, 1961.
    However, if you have held the ETFs for longer than 1 year, the profits will be classified as long-term capital gains. These gains are exempt up to the threshold limit of Rs. 1,00,000. Any long-term capital gains over this limit are taxed at 10% (without any indexation benefits).
  • Capital gains from balanced ETFs (with 35% to 65% equity investments)
    If your holdings in such balanced ETFs are sold within 3 years, the resulting profits, if any, are considered as short-term capital gains. They are added to your total income and taxed as per the income tax slab rate that applies to you.
    Profits from ETF holdings of over 3 years are categorised as long-term capital gains. The ETF tax rate for these gains is 20% (with the benefit of indexation).
  • Capital gains from non-equity ETFs and balanced ETFs (with less than 35% equity investments)
    The profits, if any, from these ETFs are always considered to be short-term capital gains. They are taxed at the applicable income tax slab rate.

Conclusion

This sums up the details of the taxation of exchange-traded funds. While ETFs do not offer any extensive tax benefits, they do come with other advantages like liquidity and easy diversification. To make the most of these advantages, ensure that you carry out a comprehensive tax planning exercise before adding ETFs to your portfolio.

Frequently asked questions

How are ETFs taxed?

The dividend earned from ETFs is taxed according to the income tax slab applicable to you. The ETF capital gains tax rate depends on the type of ETF and the duration of holding.

Is income from ETFs tax-free?

No, income from ETFs is not entirely tax-free. ETF taxation offers some relief only in the case of equity ETFs — on the long-term capital gains earned up to Rs. 1,00,000.

Are there any downsides of ETFs compared to mutual funds?

ETFs may be subject to more price fluctuations owing to their liquidity. Depending on your investment preferences, this may be an upside or a downside.

Do ETFs offer tax benefits?

Not all ETFs offer tax benefits. Only equity ETFs offer tax exemption on long-term capital gains to the extent of Rs. 1,00,000.