Deferment of taxes
The advantage of the growth option: scheme income is tax-exempt and capital gains are taxed only when units are sold, so returns compound for years before any tax is paid.
In plain language
Two investors earn exactly the same return on exactly the same portfolio. One pays tax on it every year; the other pays only when he finally sells. The second ends up richer — not because he paid less tax in total, but because the tax money stayed invested and kept earning.
That is deferment of taxes. The workbook explains it in Chapter 8: since the mutual fund schemes are tax-exempt, and the capital gains are realized only when booked, one can allow the gains to run without worrying about tax on the same. This concept is known as deferment of taxes and allows one the benefit of compounding before tax.
Chapter 2 lists it among the advantages of mutual funds as tax deferral.
How it works
Step 1 — the scheme pays no tax. A mutual fund's income — interest, dividends and capital gains — is exempt, because mutual funds are constituted as trusts for the benefit of unit-holders. Section 10(23)(D) of the Income Tax Act exempts it. If the investor earned the same income directly, tax may have to be paid in the same financial year.
Step 2 — the investor chooses when tax arises. Within a scheme the options differ only in cash flow and tax:
| Option | Tax event while holding |
|---|---|
| IDCW payout | Each distribution is added to taxable income and taxed at the applicable slab |
| IDCW reinvestment | Same as payout — taxed although no cash is received |
| Growth | None until units are sold; the NAV captures all gains |
Step 3 — compounding on the untaxed amount. The growth investor's whole return stays in the scheme and earns returns of its own. The workbook's conclusion: the growth option works out to be more tax-efficient, and tax deferral helps investors legally build their wealth faster than paying tax on income every year.
Deferment is not exemption. When units are sold, capital gains tax applies at the rates for that fund type and holding period.
A worked example
Two investors each put Rs 10,00,000 into the same debt scheme, earning 10 percent a year before tax. Both are in the 30 percent slab, and debt-oriented funds are taxed at the slab rate on gains too — so the only difference is when tax is paid. All figures are illustrative; stamp duty is ignored.
Anu — IDCW reinvestment. Every year's gain is distributed and taxed at 30 percent, so her money effectively compounds at 7 percent.
Bharat — growth. Nothing is taxed until he redeems, then 30 percent of the whole gain.
| After | Anu (taxed yearly) | Bharat: value before tax | Bharat: tax on redemption | Bharat after tax |
|---|---|---|---|---|
| 3 years | Rs 12,25,043 | Rs 13,31,000 | Rs 99,300 | Rs 12,31,700 |
| 10 years | Rs 19,67,151 | Rs 25,93,742 | Rs 4,78,123 | Rs 21,15,619 |
Same portfolio, same tax rate. Bharat is ahead by Rs 6,657 after three years and Rs 1,48,468 after ten — the value of compounding before tax.
Why NISM asks about it
Chapter 8.3 names the concept and concludes that the growth option is more tax-efficient; Chapter 2.1.5 lists tax deferral as an advantage of mutual funds; Chapter 8.1.2 supplies the reason the scheme itself pays nothing — Section 10(23)(D). Expect a question on which option is most tax-efficient (growth) and on why mutual fund income is exempt at scheme level (constituted as trusts for the benefit of unit-holders).
Common exam traps
- Deferment is not exemption. Capital gains tax is paid when units are sold.
- The mutual fund scheme pays no income tax on its interest, dividends or gains — Section 10(23)(D).
- IDCW reinvestment is taxed like payout, so it does not defer tax.
- The benefit is compounding before tax, which grows with the holding period.
- Growth option investors receive no dividend whatever the fund earns — the NAV carries the whole gain.
Where this is taught
- Series V-A · Chapter 8: Taxationintroduced here
- Series V-D · Chapter 8: Taxationintroduced here
- Series V-B · Chapter 8: Mutual fund Taxationintroduced here
Related terms
- Dividend Distribution TaxThe tax a mutual fund scheme itself deducted before paying a dividend, abolished from April 2020 — since when the payout has instead been taxed in the investor's own hands at their slab rate.
- IDCWThe renamed dividend option of a mutual fund scheme — a payout that is part income and part return of your own capital, which is why the NAV falls by exactly the amount distributed.
- Ex-dividend NAVThe NAV of a scheme after an IDCW has been paid out, lower than before by the amount distributed. Reinvestment of the IDCW happens at this NAV.
- Long Term Capital GainThe gain on mutual fund units sold after the long-term holding period — 12 months for equity-oriented funds, 24 months for most others — taxed at 12.5% on equity funds above a Rs 1.25 lakh yearly exemption.
- Marginal Slab RateThe investor's own applicable income-tax slab rate. It taxes IDCW, short-term gains on most non-equity schemes, and all gains on debt-oriented funds and debt ETFs.
- Short Term Capital GainThe gain on mutual fund units sold within the holding period — 12 months or less for equity-oriented funds, 24 months or less for most others — taxed at 20% for equity funds and at slab rate otherwise.