When investors realize the benefit of direct plans over regular plans of mutual fund schemes (like direct plans always give higher returns than regular plans), the common reaction is to try and shift from regular to direct mutual funds.
The reason for going for direct plans is simple. The regular plans have a higher expense ratio (to pay commission to MF distributor or agent) and hence give lower returns. Whereas the expense ratio of a direct mutual fund is lesser as there is no commission paid to any middle agent. So your returns are higher in these plans.
Note – If you want to see in real how large can the difference be between the expense ratios of regular and direct plans of the same fund, then do read this detailed list of mutual fund expense ratio comparisons for direct and regular plans.
Now coming back to what it means when you switch from regular plans to direct plans of mutual funds.
As per the current mutual fund taxation rules, a switch from a regular to a direct plan of the same mutual fund scheme is treated as redemption from the regular (source) plan and purchase of a direct (destination/target) plan.
That is, it is considered as a ‘transfer’ and hence, liable to capital gains tax. This is in spite of the amount remaining invested in the same mutual fund scheme (and same portfolio of stocks) and also in spite that there are no actual gains as money moves back to the same portfolio. Seems odd but those are the rules.
After the transfer, the rules are as for normal mutual fund capital gains taxation. That is:
- For equity-oriented funds, you pay short-term capital gains tax (STCG) at 15% if the holding period is shorter than 1 year. For a holding period exceeding 1 year, you pay long-term capital gains tax (LTCG) at 10% if the gains are in excess of Rs 1 lakh a year.
- For debt-oriented funds, you pay short-term capital gains tax (STCG) at the investor’s income tax slab rate if the holding period is shorter than 3 years. For a holding period exceeding 3 years, you pay long-term capital gains tax (LTCG) at 20% after indexation.
Note – You also need to bear the exit loads (if applicable) when you switch from regular to direct plans.
Given that switching from regular to direct schemes of the same funds will attract capital gains tax, should you then withdraw all your regular scheme investments at once or do it in parts?
When it comes to equity funds switching from regular to direct plans, you need to remember that every year, your long-term capital gains of up to Rs 1 lakh are tax-free. So if your gains are below this, then you can switch at once. But if your accumulated gains are much higher, you can stagger the switch and gradually sell your regular plan units over a period of time. Along with that, you can also utilize temporary sharp corrections in the market to make these shifts. A fall in the market will reduce some of your capital gains due to a fall in the fund’s NAV too. So you can use that opportunity to reduce your taxes while making the switch.
But this gradual switching approach is when you are switching from a regular plan to the direct plan of the same scheme. In case you are moving from one scheme to other due to underperformance, then it’s better to make the switch immediately and in full. Why? Because the money you plan to save in taxes might already be lost due to underperformance of the existing fund.
So that was about the tax implications when switching from regular to direct plans of your mutual funds in India 2023.