How to avoid LTCG (Long Term Capital Gains) tax on mutual funds

Learn how to optimise your investment portfolio to enhance returns and reduce tax liabilities.
EXPLORE FUNDS
How to avoid LTCG
EXPLORE FUNDS
3 mins read
26-April-2024

In the 2018 Union Budget of India, the late Finance Minister Mr. Arun Jaitley reinstated a long-term capital gains (LTCG) tax on equity investments. Prior to this change, gains from equity investments were tax-exempt if held for over a year before redemption.

Although gains from mutual funds are now taxable, there is a strategy called Tax Harvesting to legally reduce the capital gains tax on investment returns, even though complete tax avoidance may not be feasible. It may prove to be quite helpful to know how to avoid LTCG tax on mutual funds. You can take the advantage of the Bajaj Finserv SIP calculator to estimate your maturity amount as per your holding period prior to taxation, to make informed investment decisions.

Understanding taxation on mutual funds

Here are a few important points to help you understand taxation on mutual funds:

Aspect

Details

Fund types

Taxation rules vary based on the type of mutual funds: Equity, Debt, or Hybrid. Each fund type carries its own set of tax implications, necessitating awareness among investors before committing funds.

Dividends

Mutual fund companies distribute profits as dividends to investors. These dividends are subject to taxation, prompting investors to understand their tax implications.

Capital gains

Capital gains are when investors sell assets at a higher price than their initial investment. Knowledge of short-term and long-term capital gains and their respective tax rates is essential.

Holding period

The duration between the purchase and sale of mutual fund units significantly influences tax rates. Longer holding periods generally incur lower tax rates, encouraging a more tax-efficient investment approach.

 

 

How to avoid long term capital gain tax (LTCG) on mutual funds

Here are some strategies to consider to avoid long term capital gain tax (LTCG) on mutual funds:

  • Systematic Withdrawal Plan (SWP): Set up an SWP to automatically redeem your mutual fund units regularly. By keeping withdrawals below Rs. 1 lakh per year, you may avoid LTCG tax altogether.
  • Selling at the right time:
    • For gains: Consider selling some units before your total LTCG for the year reaches Rs. 1 lakh. This requires monitoring your portfolio and market conditions.
    • For losses: If you are facing long-term capital losses, selling after March 31st, 2018 (assuming this is the past) lets you offset those losses against future LTCG gains (which are now taxable).

However, most experts agree that the best approach to minimise LTCG tax is to hold your investments for the long term. This allows your gains to grow potentially without incurring LTCG tax.

Why holding on to your investment is a better option?

Selling your mutual fund holdings can trigger capital gains tax, which depends on how long you have held the investment.

Here's a breakdown:

  • Short-Term Capital Gains (STCG): Sold within 1 year - Taxed at 15% of your gains.
  • Long-Term Capital Gains (LTCG): Sold after 1 year: 
    • Up to Rs. 1 lakh per year - Exempt from tax.
    • Exceeding Rs. 1 lakh - Taxed at 10% without indexation (adjustment for inflation).

Strategies to minimise LTCG Tax:

  • Invest for the Long Term: Hold your investments for longer periods to benefit from the Rs. 1 lakh exemption and potentially avoid LTCG tax altogether.
  • Tax-Efficient Investing: Consider consistent performers and avoid frequent portfolio churning (buying and selling) to minimise taxable gains.

Choosing the right mutual funds

Here are some fund categories that can help with long-term investing:

Fund Category

Description

Benefits

Large-cap Funds

Invest in established, large companies.

Lower risk, potentially stable returns.

Mid-cap Funds

Invest in medium-sized companies.

Potential for higher growth, with some volatility.

Multi-cap Funds

Invest across companies of all sizes.

Diversification, flexibility for risk-adjusted returns.


Important Note: Sector Funds are riskier due to their focus on a specific industry. Consider them only if you have strong knowledge of that sector.

Focus on smart investing

Do not be overly concerned about LTCG tax. Focus on building a well-diversified portfolio of consistent performers to maximise your returns over time. Remember, smart investing is key to navigating market volatility and potentially overcoming tax implications.

Calculation for capital gains tax on mutual funds

To understand how to minimise your capital gains tax, it is crucial to comprehend the taxation principles governing mutual funds. “Debt-oriented” and “Equity-oriented” mutual funds, are subject to distinct tax regimes, outlined as follows.

Gains from Debt Mutual Funds held for 3 years (36 months) or less before redemption are deemed Short Term Capital Gains (STCG) and taxed at your slab rate, potentially reaching up to 30%. Units held for over 3 years qualify for Long Term Capital Gains (LTCG) tax. Pre-Budget 2023, LTCG on debt funds attracted a 20% tax with indexation benefit. Post-Budget 2023, gains from debt funds made post April 1st 2023, will be taxed according to your income tax slab, without indexation benefit.

For Equity Funds, gains from units held up to 1 year (12 months) before redemption are considered Short Term Capital Gains (STCG) and taxed at a rate of 15%. If held for over 1 year, they attract Long Term Capital Gains (LTCG) tax. LTCG tax for Equity Mutual Funds is 10% on gains exceeding Rs. 1 lakh annually. Thus, if your total gains are Rs. 1.2 lakh, only Rs. 20,000 is taxable at 10%, while the remaining Rs. 1 lakh remains tax-free.

Hybrid mutual funds are subject to specific taxation rules based on their equity and debt components. For the equity component, similar to equity funds, long-term capital gains are taxed at 10% on profits exceeding Rs. 1 lakh annually, while short-term capital gains incur a 15% tax. On the other hand, the debt component follows the taxation structure of pure debt funds. Capital gains from the debt part are added to your income and taxed according to the applicable income tax slab. Long-term capital gains from the debt component attract a 20% tax with indexation benefits and a 10% tax without indexation benefits.

Note: Compare different mutual fund details, returns, scheme allocations, fund manager information, expense ratios, and many more on Bajaj Finserv Mutual Funds Compare page to estimate your net returns prior to the taxation and make your every investment count.

Strategies for minimising capital gains tax on mutual funds

  • Tax harvesting: Tax harvesting involves selling a portion of equity mutual fund units annually to realise long-term gains and reinvesting the proceeds into the same fund. This strategy helps investors keep their long-term returns below the Rs. 1 lakh threshold, thus avoiding long-term capital gains tax upon redemption.
    For example, if an investor invested Rs. 4 lakh in an equity fund in February 2024, with a 20% annual return, and redeemed it in March 2025 for Rs. 4.80 lakh, the capital gains of Rs. 80,000 remained tax-free as they stayed below the Rs. 1 lakh threshold for that assessment year.
  • Leveraging losses: Capitalising on losses involves realising long-term capital losses to offset against other long-term capital gains, effectively reducing the capital gains tax burden.
    For example, if an investor incurred a loss of Rs. 50,000 on an investment valued at Rs. 1.85 lakh in February 2024, they could offset this loss against any long-term capital gains realised in the same year. This allows investors to reduce their payable capital gains tax.

Conclusion

In conclusion, mutual fund investments require a thorough understanding of taxation principles to optimise returns and minimise tax liabilities. The strategies discussed, such as tax harvesting and leveraging losses, offer valuable tools for you to mitigate capital gains tax burdens effectively.

By implementing tax harvesting, you can strategically manage your equity mutual fund holdings to keep long-term returns below the Rs. 1 lakh threshold, thus avoiding long-term capital gains tax upon redemption. Additionally, capitalising on losses enable you to offset long-term capital losses against gains, reducing your overall tax liabilities.

It is essential for you to evaluate your investment goals, risk tolerance, and tax implications carefully. Moreover, staying informed about regulatory changes and tax policies is crucial for making informed investment decisions.

In essence, by employing prudent tax planning strategies, you can enhance overall investment outcomes and build long-term wealth. If you are looking for an easy way to invest in mutual fund schemes, visit the Bajaj Finserv Mutual Fund Platform today. With over 1,000 different fund options to choose from, you can surely find one that fits your requirements.

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Frequently asked questions

Is Long-Term Capital Gains on mutual funds taxable?

Yes, long-term capital gains on mutual funds are taxable, subject to specific tax rates based on the holding period and the type of mutual fund.

Are mutual fund returns taxed as capital gains or ordinary income?

Mutual fund returns are taxed differently based on the type of income they generate. Capital gains from mutual funds are subject to capital gains tax, whereas dividends are taxed as ordinary income based on the investor's tax slab.

How to calculate tax on long-term capital gain on a mutual fund?

The calculation method for LTCG tax depends on the type of mutual fund:

Equity Funds (held over one year):

  1. Determine LTCG: LTCG = Selling Price (including dividends) - (Indexed Cost of Acquisition + Expenses)
  2. Apply tax rate: For LTCG exceeding Rs. 1 lakh in a financial year, a 10% tax rate applies, with a 4% cess (effectively 10.4%).

Note: Indexation adjusts the purchase price for inflation, potentially reducing your LTCG and tax liability.

Debt Funds (held over three years):

  • Determine LTCG: Selling Price (including dividends) - (Indexed Cost of Acquisition + Expenses)

Apply tax rate: LTCG is taxed at 20% with indexation benefits. However, there's no exemption for the first Rs. 1 lakh like equity funds.

Is LTCG on mutual funds exempt under any section?

Yes, partially. Up to Rs. 1 lakh of LTCG earned from equity-oriented mutual funds (including ELSS) is exempt from tax under Section 80C of the Income Tax Act.

Additional points to consider:

  • Short-term capital gains (held less than one year) from equity funds are taxed at your income tax slab rate.
  • Debt funds held for less than three years are treated as short-term capital gains and taxed as per your income tax slab rate.
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