Tax Efficiency of ETFs: What Indian Investors Need to Know

How Are ETFs Taxed in India?

The taxation of ETFs in India depends on the type of ETFs and the holding period. The table below summarizes the tax structure of ETFs:

Taxation on Dividend Income

Earlier, ETFs and mutual funds were subject to a Dividend Distribution Tax (DDT), where a 15% tax was deducted at the fund level before distributing dividends to investors. However, since FY 2021, the government abolished DDT. Now, any dividend received from ETFs is added to the investor’s total income and taxed as per their income tax slab rate. This means that investors in higher tax brackets will have to pay more tax on their dividends compared to earlier, making tax-efficient investment strategies even more important.

Why Are ETFs More Tax-Efficient Than Mutual Funds and Stocks?

ETFs offer tax advantages compared to mutual funds and stocks. Here’s why:

Lower Taxable Transactions - Unlike actively managed mutual funds, ETFs do not involve frequent buying and selling of stocks within the fund. This reduces capital gains distributions, meaning investors are not taxed on gains triggered by fund manager transactions. In contrast, mutual funds may distribute capital gains even if an investor has not sold their units, leading to additional tax liabilities.

Cash-Based Redemptions in India - In countries like the U.S., ETFs benefit from an “in-kind” creation and redemption mechanism that minimizes tax impact. However, in India, ETF redemptions are cash-based, meaning the fund may have to sell securities to meet redemption requests, potentially triggering taxable events. While this limits some tax advantages seen in international markets, ETFs in India still remain tax-efficient due to their passive management and lower portfolio turnover.

Reinvestment of Dividends Within the ETF - One major tax advantage of ETFs is that when companies within the ETF pay dividends, those dividends are generally reinvested within the fund itself, rather than being distributed to investors. This means investors do not receive direct dividend payouts and, as a result, do not incur annual dividend tax liabilities. Instead, the reinvested dividends contribute to the ETF’s overall value, allowing investors to benefit from tax-free compounding until they sell their units.
 

How to Minimize Taxes When Investing in ETFs

There are several techniques that investors can use to minimize their taxes on ETFs. A few of them are:

Hold Your ETFs for the Long Term - Long-term capital gains tax rates are lower than short-term rates. If you hold an equity ETF for more than one year or a debt ETF for more than three years, you may pay lower taxes.

Use Tax-Loss Harvesting - If your ETF investment is in loss, you can sell it before the financial year ends and offset the loss against other taxable gains, reducing your tax liability.

Plan Systematic Withdrawals - Instead of selling a large number of ETF units at once, withdraw smaller amounts over multiple financial years to spread out tax payments and reduce the overall tax burden.
 

Are ETFs a Tax-Friendly Investment?

ETFs are one of the most tax-efficient investment options available to Indian investors. Compared to mutual funds and direct stock trading, they generally offer lower taxable distributions, better tax deferral benefits, and fewer capital gains events. However, investors should always consider their financial goals and tax implications before making investment decisions.

For those looking for a smart, tax-efficient way to invest, ETFs may provide a great balance of growth potential and tax savings. Understanding the taxation of ETFs will help you make informed decisions and maximize your returns over time.