There are two ways in which you can receive income from a mutual fund - one is the dividend income and the other is the dividend re-investment method.
Now, if you opt for the dividend income, one must note that it is not taxable. This means neither would TDS be deducted, nor would you have to add the income to total income while filing income tax returns. This is true for debt and equity mutual fund schemes.
If the dividend is re-invested and you sell the units at the net asset value, then you are liable to pay capital gains tax if there is a profit.
The long term capital gains tax on a equity mutual fund scheme is tax exempt. On the other hand a short term capital gains tax of 15 per cent is payable in the case of an equity scheme.
On debt schemes, the following manner of Capital Gains shall apply:
Long term capital gains - Taxed at the rate of 20 per cent (with Indexation) or 10 per cent (without Indexation) - Plus applicable surcharge and Education cess
Short term capital gains - Taxed at the normal rate of tax as applicable to the assessee.
Why you should invest through mutual funds?
Equities are often risky and if you lack the understanding you could end-up losing money. Hence, it's better to invest in equity schemes of mutual fund. Also, the dividend option of equity mutual fund schemes offer tax free dividends. So, if your looking at superior returns, then equity mutual fund schemes are the best bets. Of course, one must also know that they are risky as well and returns are not guaranteed like bank fixed deposits.