How to Avoid LTCG Tax on Mutual Funds

In the 2024 Union Budget of India, Finance Minister Nirmala Sitharaman reintroduced the long-term capital gains (LTCG) tax on equity investments. This move marks a significant shift in the tax policy concerning equity investments. Prior to this amendment, any gains derived from equity investments that were held for a period exceeding one year were entirely exempt from taxation. This exemption had made long-term equity investments particularly attractive to investors. However, with the reinstatement of the LTCG tax, investors will now be required to pay taxes on the profits earned from these investments, even if they are held for more than a year before redemption. This change aims to increase government revenue and create a more balanced tax structure.

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.

To avoid long-term capital gains (LTCG) tax on mutual funds, you can utilise a few strategic approaches. For debt funds, staying invested for three years or longer allows you to benefit from indexation, reducing your taxable gains at the time of redemption. With equity mutual funds, LTCG tax is only applicable if your annual returns exceed Rs. 1 lakh. By managing your investments and timing your redemptions effectively, you can minimize or even avoid LTCG tax on your mutual fund investments. Read the full blog to learn more.

The Union Budget 2024-25: Changes in taxation for mutual funds

The Union Budget 2024-25 introduced several significant changes in the taxation of mutual funds. One notable change is the reintroduction of the long-term capital gains (LTCG) tax on mutual fund investments. Gains from mutual funds held for more than a year will now be taxed at 12.5%, without the benefit of indexation. Short-term capital gains (STCG) tax rates remain unchanged at 20% for equity-oriented funds. Additionally, the dividend distribution tax (DDT) has been removed, and dividends are now taxable in the hands of investors at their applicable income tax rates. These changes aim to enhance tax compliance and revenue generation.

Understanding taxation on mutual funds

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

Is there a way to reduce capital gains tax on short term gains?

Reducing capital gains tax on short-term gains can be challenging, but there are a few strategies to consider. Offset gains with capital losses by selling underperforming investments, a tactic known as tax-loss harvesting. Utilise tax-advantaged accounts such as ISAs, which shield gains from tax. Additionally, consider holding investments longer to benefit from lower long-term capital gains rates. Strategic gifting or charitable donations of appreciated assets can also provide tax relief. Consulting a financial advisor is advisable to ensure compliance with tax regulations while maximising potential savings.

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.

How tax harvesting helps reduce capital gains tax?

Tax harvesting, or tax-loss harvesting, is a strategy employed by investors to reduce their capital gains tax liability. This involves selling investments that have decreased in value to offset the capital gains realised from the sale of profitable investments. By balancing the gains with losses, the overall taxable capital gains can be significantly reduced.

For instance, if an investor has realised a capital gain of Rs. 10,000 from the sale of a successful investment, but also has an investment that has lost Rs. 4,000, selling the underperforming asset can offset the gain. The net taxable gain would then be reduced to Rs. 6,000, thereby lowering the capital gains tax owed.

This strategy can be particularly beneficial towards the end of the financial year, allowing investors to make strategic decisions about their portfolios. Additionally, the losses can be carried forward to offset future gains if they exceed the current year's gains.

It’s essential, however, to adhere to the ‘bed and breakfast’ rule in the UK, which prevents repurchasing the same or a substantially similar investment within 30 days of the sale. This rule ensures that the sale is not merely a superficial transaction designed solely for tax benefits. Consulting with a financial advisor can help navigate these rules and optimise the tax benefits of harvesting losses.

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 20% of your gains.
• Long-Term Capital Gains (LTCG): Sold after 1 year: 
  • Up to Rs. 1.25 lakh per year - Exempt from tax.
  • Exceeding Rs. 1.25 lakh - Taxed at 12.5% 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. 1.25 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:

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 1^st 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 20%. If held for over 1 year, they attract Long Term Capital Gains (LTCG) tax. LTCG tax for Equity Mutual Funds is 12.5% on gains exceeding Rs. 1.25 lakh annually. Thus, if your total gains are Rs. 1.45 lakh, only Rs. 20,000 is taxable at 12.5%, while the remaining Rs. 1.25 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 12.5% on profits exceeding Rs. 1.25 lakh annually, while short-term capital gains incur a 20% 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%.

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. 1.25 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.

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