Are Inherited Mutual Funds Tax-Free or Not?

Mutual funds have grown into one of the most favoured investment avenues in India due to their relatively low entry barrier, diversification benefits, and long-term wealth creation potential. 

But while most investors understand the taxation of mutual funds during their lifetime, fewer are aware of how these funds are treated when inherited. If you’ve recently inherited mutual funds—or are planning your estate—it’s important to grasp the nuances of taxation related to such transfers.

No Tax on Inheritance Itself

As of today, India does not levy an inheritance tax or estate duty. This stems from the abolition of the Estate Duty Act back in 1985. As a result, when a person inherits mutual fund units—whether they be equity, debt, or hybrid—there is no tax levied at the point of transfer. These units are passed on either to the nominee or legal heir seamlessly, without any immediate tax implications.

However, the story changes when the heir decides to redeem or sell these inherited units. That’s when taxation comes into the picture.

Cost of Acquisition and Holding Period

The 2 most critical elements that influence taxation upon selling inherited mutual funds are the cost of acquisition and the holding period.

• Cost of Acquisition: As per Section 49(1) of the Income Tax Act, the cost of acquisition is considered to be the amount originally paid by the deceased investor. 
• Holding Period: The duration of holding is also inherited. The period starts from the date the deceased acquired the mutual fund units, not from the date they were inherited. This provision can work favourably for the heir, especially if the original investment was made long ago, potentially qualifying the gains as long-term.

Taxation on Redemption of Inherited Mutual Funds

When the legal heir or nominee redeems the mutual fund units, capital gains tax applies. The rate and structure of tax depend largely on the type of mutual fund and the original holding period.

Equity Mutual Funds

• Short-Term Capital Gains (STCG): If the inherited units are sold within 12 months from the original date of purchase, the gains are taxed at 20% plus applicable surcharge and cess under Section 111A.

• Long-Term Capital Gains (LTCG): If held for over 12 months, the gains qualify as long-term. LTCG up to ₹1.25 lakh per financial year is tax-exempt. Gains beyond that are taxed at 12.50% (plus surcharge and cess), with no indexation benefit, as per Section 112A.

Debt Mutual Funds

The taxation on debt mutual funds depends on whether they were purchased before or after 1 April 2023.

• For investments made after 1 April 2023: All capital gains, regardless of the holding period, are taxed at the investor’s applicable income tax slab rate. This rule also applies to inherited debt mutual funds.

• For investments made before 1 April 2023: If the deceased held the debt fund units for more than two years, and the heir continues to hold them beyond that period, the gains qualify for long-term capital gains. LTCG from such funds is taxed at 12.50% plus applicable surcharge and cess.

Tax Implications for Nominees and Legal Heirs

• Nominee vs Legal Heir: While a nominee is the first point of transfer, they essentially act as a trustee until the rightful legal heir is determined. Regardless of whether the units are first passed on to a nominee or directly to the heir, the tax treatment remains consistent.

• Joint Holders: If mutual funds are held jointly with the right of survivorship, the surviving holder becomes the sole owner upon the other’s death. The cost and holding period continue unchanged.

Exemptions and Deductions

• Equity LTCG Exemption: The ₹1.25 lakh annual exemption on LTCG from equity mutual funds is available to the heir, provided the gains meet long-term conditions.

• No Special Deductions: There are no specific deductions under Section 80C or other provisions for inherited mutual funds unless the proceeds are reinvested in eligible schemes.

A Practical Illustration

To bring this to life, let’s consider an example cited by Shinghal:

Mr A purchased 10,000 units of an equity mutual fund in January 2020 at ₹100 per unit, amounting to a total investment of ₹10 lakh. Upon his demise in January 2025, his daughter, Ms B, inherited the units, which were worth ₹200 per unit at the time (total value: ₹20 lakh). Ms B sold them in June 2025 at ₹250 per unit (total proceeds: ₹25 lakh).

• Original Cost: ₹10 lakh
  
• Holding Period: January 2020 to June 2025 (more than 12 months) – LTCG applicable
  
• Capital Gains: ₹25 lakh – ₹10 lakh = ₹15 lakh
  
• Exempted Gains: ₹1.25 lakh
  
• Taxable Amount: ₹13.75 lakh
  
• Tax Payable: 12.50% of ₹13.75 lakh = ₹1,71,875 (excluding surcharge and cess)

Conclusion

Understanding these provisions helps ensure that beneficiaries of mutual funds navigate the tax implications correctly. Still, given the complexities and potential changes in tax regulations, seeking professional advice is always advisable in such matters.

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. This does not constitute a personal recommendation/investment advice. It does not aim to influence any individual or entity to make investment decisions. Recipients should conduct their own research and assessments to form an independent opinion about investment decisions. 

Mutual Fund investments in the securities market are subject to market risks, read all the related documents carefully before investing.