Chapter Three
The fund categories, decoded
What each type holds, who it suits, how it is taxed
The short version
There are about ten categories worth knowing. Pick five. The tax treatment matters as much as the returns.
The map
There are hundreds of funds and about ten categories.
Fund names are marketing. Categories are regulated — SEBI defines what each one must hold, which means the category tells you far more about a fund than its name does. Learn the categories and the hundreds of schemes collapse into a manageable menu.
Read across three columns for any fund you are considering: what it holds, how long you need to hold it, and how the gain is taxed. The third column is the one people skip and the one that most often changes the answer.
Return ranges are long-run typicals, not promises. Any category can and does deliver less over any given five-year stretch.
The category worth knowing about
Equity savings funds, and the trick hiding inside them.
Most people park spare cash in a liquid fund or a fixed deposit, earn about 7%, and hand roughly a third of that back as tax because debt gains are added to your income at your slab rate. On a 30% slab, a 7% return quietly becomes about 4.9%.
An equity savings fund is built to sidestep this. It holds only about 15% in real equity; another 20-35% sits in arbitrage — buying a share and simultaneously selling its futures contract to capture the price gap, which produces a debt-like return with almost no market risk. The rest is debt.
Because arbitrage positions are legally equity, the fund clears the 65% threshold and gets equity tax treatment. Hold it twelve months and you pay 12.5% instead of 30%. The return is a little higher too — roughly 8-10%, with the small equity sleeve adding the kicker — and the risk stays modest because only about a seventh of the fund is genuinely exposed to the market.
Liquid fund, 30% slab
~4.9%
after tax, on a 7% return. Available the next working day, with no minimum holding period. The right home for one month of expenses and nothing more.
Equity savings fund, held 12 months
~7.9%
after tax, on a 9% return. Needs twelve months to get there and can dip slightly in a sharp fall. For reserve money beyond the first month, the gap is worth the wait.
Taxation
Four rules, and the one that catches everybody.
Tax is not a footnote to fund selection — it is part of the return. Two funds returning the same 10% can leave you with very different amounts depending on what they hold and how long you held them.
| Fund type | Long-term line | Sold before | Sold after |
|---|---|---|---|
| Equity fundsThe first ₹1.25 lakh of long-term equity gains in a financial year is exempt. A couple with separate portfolios gets that allowance twice. | 12 months | 20% | 12.5% |
| Equity savings & most hybrids above 65% equityThe 65% equity threshold is what buys the equity tax treatment. Read the scheme document rather than the category name. | 12 months | 20% | 12.5% |
| Debt funds — liquid, ultra short, conservative hybridBought after 1 April 2023, these are taxed at your income slab regardless of holding period. On a 30% slab that is the whole argument for using an equity savings fund instead. | No line | Your slab | Your slab |
| Fund of funds and most international fundsTwo years, not one. Enter these with a 24-month floor or the tax quietly eats a third of the gain. | 24 months | Your slab | 12.5% |
| Gold and silver fundsSame 24-month line as fund of funds. Holding gold inside a multi-asset fund sidesteps this entirely. | 24 months | Your slab | 12.5% |
There is one more piece of tax arithmetic that matters more than any of the rates: a gain you never realise is a gain you never pay tax on. Money not handed to the government stays in the fund and compounds alongside everything else. Fifteen years of never selling is not just a discipline — it is a materially better after-tax outcome than the same returns harvested and re-deployed.
This is also the strongest argument for funds over managed portfolio services, and for a fund of funds over rotating between sector funds yourself. When the manager switches sectors inside the fund, no sale happens in your name and no tax event is triggered. When you switch, one is.
What the tax actually costs
What kind of fund
Only matters for debt funds and short-term FoF gains
Treated as
Long term
Rate applied
12.5%
Tax you owe
₹34,375
Held over 12 months. The first ₹1.25 lakh of equity gains each year is exempt; the rest is taxed at 12.5%.
The first ₹1.25 lakh of this gain was exempt, so only ₹2,75,000 was taxed. Redeeming in slices across financial years lets you use that allowance more than once — a real and entirely legal way to reduce the bill on a large holding.
Reflects the regime after July 2024. Rates and thresholds change with each budget — confirm current rules before you redeem anything. Surcharge and cess are not included here.
Housekeeping
Two smaller choices that are worth getting right.
Direct or regular plan
Identical portfolio, two price tags. A regular plan builds a distributor commission into its expense ratio; a direct plan does not, and returns roughly 0.5-1% more a year as a result. Over twenty years that gap is large.
The honest counterweight: the commission buys advice, and the single most valuable thing an adviser does is stop you redeeming in a crash. If having someone to call is what keeps you invested, a regular plan is cheaper than quitting.
Growth or dividend option
Choose growth, in almost every case. The dividend option — now called income distribution — pays out of your own capital and taxes the payout at your slab rate, which for most people is worse than simply selling units when you need money.
If you need a monthly income later, a systematic withdrawal plan out of a growth option does the same job with better tax treatment, because only the gain portion of each withdrawal is taxed.