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As an investor, tax on capital gains from your mutual fund investments can have a significant impact on the returns you earn and also impact your financial goals. Although the short-term capital gains tax on equity funds, for transfers effected on or after 23rd July 2024, is a homogeneous 20%, the long-term capital gains (LTCG) tax provides some ways of planning that can reduce your tax liability.
If you hold units of your equity oriented mutual fund schemes for more than 1 year and of debt mutual funds for transfers effected on or after 23rd July 2024 for more than 2 years for such unlisted schemes and more than 1 year for such listed schemes, you will have to pay LTCG tax. Let us see how you can minimize the same.
Analysing Long Term Capital Gains Tax Rules
The first step is developing an in-depth understanding of how LTCG tax is calculated on different categories of mutual fund schemes. This section examines the key rules and thresholds governing LTCG tax.
Equity Mutual Funds
LTCG if held for more than 1 year
Gains up to Rs. 1.25 lakh per financial year exempt from LTCG tax
LTCG tax rate is 12.5% only on gains above Rs. 1.25 lakh
No indexation benefit, tax applied on total capital gains
Debt Mutual Funds
Long term capital gains in respect of units of such schemes held for more than 36 months is chargeable to tax @ 20% after factoring the cost inflation index.
However, for transfers effected on or after 23rd July 2024, LTCG tax on the units of such schemes will be 12.5% without indexation.
For transfers effected on or after 23rd July 2024, period of holding for being treated as long term capital gain has been reduced to more than 2 years for such unlisted schemes and more than one year for such listed schemes. The entire capital gains is subject to LTCG tax unlike equity oriented mutual funds where LTCG upto Rs.1.25 lacs are exempt.
For debt mutual funds which fall under the Specified Mutual Fund category, please refer to the contents mentioned below.
Hybrid Mutual Funds
Tax treatment of hybrid funds depends on whether the scheme is equity oriented or debt oriented. It is always recommended to consult a tax expert when in doubt about the finer details related to mutual funds taxation.
As visible, equity and debt funds have different holding periods, tax rates and exemptions governing LTCG tax. For equity mutual funds, the Rs 1.25 lakh yearly exemption threshold is a key aspect that allows LTCG tax planning.
Planning for Equity Fund LTCG Tax
For equity mutual funds such as large cap, multi cap, mid cap, thematic, and equity oriented hybrid funds, LTCG tax of 12.5% applies on gains above Rs. 1.25 lakh in a financial year if held for more than 1 year. Several strategies can help minimise your LTCG tax exposure.
1. Remaining Under the Rs. 1.25 Lakh Threshold
The simplest approach is to plan redemptions and withdrawals such that your total long term capital gains in a financial year are less than Rs 1.25 lakh. This entirely eliminates incurring any LTCG tax, allowing you to enjoy tax-free growth on your equity mutual funds.
For example, you have LTCG of Rs. 90,000 gains from equity mutual funds in April. You can redeem additional units in a manner that you earn Rs. 35,000 further as long LTCG upto March of the same financial year, taking the total capital gains for the financial year to Rs. 1.25 lakh. No LTCG tax will apply in this case.
2. Using a Systematic Withdrawal Plan (SWP)
Setting up an SWP allows you to redeem fixed amounts periodically, such as monthly or quarterly withdrawals. By calibrating your withdrawal amounts, you can ensure the total long term capital gains stay within the Rs. 1.25 lakh limit each financial year.
For instance, you could opt for monthly SWP instalments in a manner that you earn LTCG upto Rs.1,25,000/- in a financial year. This results in your yearly withdrawals meeting the twin objectives of meeting your expenses and keeping your tax nil in a legally permissible manner. SWPs provide a flexible approach to minimize LTCG tax.
3. Tax Loss Harvesting to Offset Gains
Tax loss harvesting involves selling funds with losses to offset the capital gains from other investments. Suppose you have units of an equity mutual fund with Rs. 2 lakh LTCG but another holding in a equity mutual fund has long term capital loss of Rs. 1.5 lakh loss. You can
a) either sell the loss-making fund and this loss can be carried forward upto a maximum of 8 financial years. When you sell the equity mutual fund which is making profit, the carried forward long term capital loss can be set off against this long term capital loss reducing your tax liability,
b) or you may sell both the holdings in the same financial year. Your loss of Rs.1.5 lacs will be adjusted against the LTCG of Rs. 2 lacs.
It may be noted that long term capital loss can be set off only against long term capital gains and loss under Capital Gains cannot be set off against income under other heads of income.
4. Strategically Timing Redemptions
Based on capital market conditions, equity mutual funds may see higher absolute gains in certain financial years. By monitoring your portfolio, you can estimate whether the Rs. 1.25 lakh limit may be breached.
In such cases, you can redeem units in advance, before the March 31st financial year closing. This ensures your long term capital gains remain within the tax-free LTCG threshold for that year.
5. Avoiding Unnecessary Buying and Selling
Frequent buying and selling of equity mutual funds can create taxable events that deplete your tax exemption limit. Developing a long-term investment approach focused on quality funds can reduce portfolio churn. This allows your investments additional time to build LTCG gains up to Rs. 1.25 lakh each year without triggering taxes.
The key is proactively managing your equity mutual fund portfolio based on both market conditions and your estimated LTCG position. Tax implications should be a key criteria along with your investment vision and financial plan.
Specified Mutual Funds
Debt mutual fund taxation rules were changed from April 1, 2023 with the introduction of Section 50AA. This section created a new category called “specified mutual funds.” These were defined as funds with less than 35% investment in domestic equities. As a result, they lost the benefits of indexation and the distinction between long- and short-term capital gains. All capital gains were taxed at the investor’s income tax slab rate regardless of the holding period.
The definition of “specified mutual funds” was revised again in the July 2024 budget. Now, any fund with 65% or more of its portfolio in debt and money market instruments falls into this category. Therefore, capital gains arising out of transfer of units of pure debt funds, debt-oriented conservative hybrid funds, or debt-oriented fund-of-funds with at least 65% allocation to debt, regardless of the holding period will be taxed as STCG.
Thus, capital gains arising out of all investments made on or after 01st April 2023 in Specified Mutual Funds will be short term capital gains.
Notes:
STT is also applicable besides STCG and LTCG tax on equity mutual funds. The tax is to increased by applicable surcharge. Further, Health and Education Cess @ 4% is to be charged on amount of tax and surcharge.
Conclusion
Employing strategies like tax loss harvesting, systematic withdrawal plans, long term holding and monitoring gains can help you significantly reduce LTCG tax on mutual fund investments. This allows you to build wealth efficiently. Consult a financial advisor and invest wisely. With prudent planning, you can reap higher returns and achieve financial goals faster.
The information stated herein is based on our understanding of the tax laws [Income Tax Act 1961 as amended] and is only for the purpose of providing general information to the investors of the Mutual Fund Schemes and is not exhaustive and investors are advised to read and understand the scheme related documents carefully.
Chaitanya Financial Consultants shall not be responsible in any manner whatsoever including for any information given herein. The investors should not treat the contents herein as advice relating to legal, taxation, investment or any other matter and are advised to consult its/his or her own tax/legal consultant with respect to the tax implications arising out of his or her or their participation in the Schemes.
Disclaimer:
The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. All complaints regarding Mutual Fund can be directed towards visit www.scores.gov.in (SEBI SCORES portal). Readers are requested to make informed investment decisions and consult Chaitanya Financial Consultants – 9000628943 / mfd.mmr@gmail.com to determine the financial implications with respect to investing in Mutual Funds.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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