SEBI has reportedly proposed that switching from one mutual fund to another shouldn’t trigger LTCG tax, if the units have been held for over a year (time required to qualify as long term). If this proposal becomes law (fingers crossed!), it would be one of the most investor-friendly changes in years.
As of today, many investors are stuck in underperforming funds because they face a simple calculation: Exit and pay 12.5% on whatever gains they have now, or stay and hope fund performance improves soon. Many stay. Not because the fund is good, but because leaving is expensive tax-wise.
It also makes logical sense in my view. Moving from one fund to another isn’t exactly cashing out. You aren’t taking the money home. So why tax it?
This also helps in periodic rebalancing. Reviewing and rebalancing/adjusting a portfolio after 12 months without a tax penalty means more people will actually start doing it instead of avoiding it for tax reasons.
Then there is the Direct Vs Regular Plans decision. A lot of legacy AUMs in regular plans hasn’t moved to direct plans because the switch itself creates a tax event and most investors don’t want to pay tax unnecessarily. But if this proposal removes tax in fund-switches, then many would switch to direct plans (for higher returns given lower expense ratio).
But a few operational aspects remain to be seen. Like what happens when someone switches from an equity fund to a debt fund? Does the holding period carry over? Is the gain exempt, or just deferred with the cost carried forward, etc. etc….
And there’s a possible unintended consequence. If switching after a year is tax-free, then many would be encouraged to start switching unnecessarily, running after the previous year’s table toppers. So the churn in fund space may increase a lot more than what many would anticipate now.
But let’s remember, this is still just a proposal (reportedly). Let’s see if it really sees the light of day.
My tweet on this – link
My post on LinkedIn on this – link