Effective ways to reduce long-term capital gains tax (LTCG) on mutual funds

Posted On: 20 February 2025

Mutual funds can help investors potentially build wealth over time. However, taxes on the profits can bring down net returns.

However, through careful planning, investors can optimise their taxes. This article tells you more about how mutual funds are taxed and strategies to reduce tax outgo.

Table of contents

Capital gains tax on mutual funds after Union Budget 2024
Understanding capital gains tax
How to reduce short-term capital gains tax
Strategies to minimise long-term capital gains tax
Tax harvesting
Benefits of long-term holding
Calculating capital gains tax

Capital gains tax on mutual funds after Union Budget 2024

One of the main sources of taxes on mutual funds is capital gains tax. Capital gains are the difference between the purchase price and sale price of an asset. In other words, if investors make a profit when selling their mutual fund units, that amount is taxable. The tax amount depends upon the type of scheme and the holding period. Here’s the current tax rate as per the 2024 Budget.

1. Equity mutual funds

Short-term gains (STCG)
- Tax at 20% for investments sold within 12 months.
Long-term gains (LTCG)
- Taxed at 12.5% for units held for more than 12 months.
- However, gains of up to Rs.1.25 lakh in a financial year are tax-exempt.

2. Debt mutual funds

Taxation: Currently, all gains arising from sale of debt fund units purchased after March 31, 2023 are deemed to be STCG regardless of the holding period and taxed per the investor’s income slab.
Units purchased before March 31, 2023: Gains from units sold after being held for 24 months are considered LTCG and taxed at 12.5% without indexation (if redemption is done on or after July 23, 2024).

3. Hybrid funds

Debt-oriented funds (less than 65% equity): Taxed like debt funds (slab rates).
Equity-oriented funds (65%+ equity): Taxed like equity funds (20% STCG, 12.5% LTCG).
Hybrid funds with more than 35% but less than 65% equity: Considered short-term capital gains if held for less than 24 months. STCG is taxed as per slab rates. LTCG (levied on units held for 2 years or more) is taxed at 12.5%

Understanding capital gains tax

Capital gains tax applies when you sell an asset for more than its purchase price. It has two types.

1. Short-term capital gains (STCG)

Applies to assets held briefly for less than a certain period. The duration depends upon the asset class.
For example, for equities and equity funds, STCG is levied if units are held for less than a year. For some other asset classes such as real estate, it is 24 months. Debt funds are deemed to be STCG regardless of holding period.

2. Long-term capital gains (LTCG)

Applies to assets held beyond a threshold (e.g., 12 months or 24 months).
Equity fund units sold after 12 months attract LTCG.

How to reduce short-term capital gains tax

Here are some ways in which investors can reduce their tax burden

1. Hold investments longer

Qualify for long-term gains tax by extending the holding period.
- Equity funds: Hold for 12+ months.

2. Offset gains with losses

Sell underperforming investments to balance profits.
- For example,
  - Gain: Rs.1.5 lakh (equity fund).
  - Loss: Rs.50,000 (debt fund).
  - Net taxable gain: Rs.1 lakh.

3. Use tax-saving instruments

If you have opted for the old regime, invest in tax-saving avenues such as PPF, NSC or ELSS (Equity-Linked Savings Scheme) to claim deductions of up to Rs.1.5 lakh in a financial year under Section 80C of the Income Tax Act, 1961.

Strategies to minimise long-term capital gains tax

1. If investing in equity funds, stay under or close to the Rs.1.25 lakh annual exemption limit.

Spread redemptions across financial years.
- For example,
  - Gain: Rs.2.5 lakh.
  - Sell Rs.1.25 lakh in March 2025 and Rs.1.25 lakh in April 2025.
  - Both amounts qualify for exemption.

2. Tax-loss harvesting

Sell loss-making units to offset gains.
- For example,
  - Gain: Rs.3 lakh (Fund A).
  - Loss: Rs.1.2 lakh (Fund B).
  - Taxable gain: Rs.1.8 lakh. After exemption, tax applies to Rs.55,000.

3. Invest in equity-linked savings schemes (ELSS)

Locks funds for 3 years.
Offers dual benefits -
- Section 80C deduction.
- LTCG tax rate (12.5%) after 12 months.

4. Systematic withdrawal plans (SWPs)

Withdraw small amounts annually to stay under the Rs.1.25 lakh exemption.
- For example, withdraw Rs.1.25 lakh/year from a Rs.10-lakh investment over 8 years.

Tax harvesting

Review your investment portfolio and identify funds or assets that have unrealised gains and losses. Make a list of both.
Calculate your net capital gains by subtracting your total capital losses from your total capital gains. This is the amount of gains you need to offset.
Consider periodically harvesting losses in the future to further optimise your taxes.

Benefits of long-term holding

1. Lower tax rates

LTCG tax (12.5%) on equity funds is lower than STCG tax (20%).

2. Compounding growth

Reinvested gains grow exponentially over time.
- For example, Rs.10 lakh at 12% annual returns can becomes Rs.31 lakh in 10 years.

Calculating capital gains tax

Let us take two examples to understand how to calculate capital tax.

Case 1 - Equity fund investment

Purchase Price (Jan 2023): Rs.8 lakh.
Sale Price (Feb 2024): Rs.12 lakh.
Holding Period: 13 months (LTCG).
Taxable Gain: Rs.12 lakh – Rs.8 lakh – Rs.1.25 lakh = Rs.2.75 lakh.
Tax: 12.5% of Rs.2.75 lakh = Rs.34,375.

Case 2 - Debt fund investment

Purchase Price (March 2022): Rs.15 lakh.
Sale Price (August 2024): Rs.18 lakh.
Holding Period: 29 months (deemed STCG).
Taxable Gain: Rs.18 lakh – Rs.15 lakh = Rs.3 lakh.
Tax: As per applicable income tax slab rate

Note: This estimate does not include any applicable surcharge or cess.

Conclusion

While completely avoiding long-term capital gains may not be possible, the strategies given above can help reduce tax burden. Aim for long-term investing in equity-oriented mutual funds to get the advantage of potentially compounded growth and reduced tax rates.

FAQs:

Are long-term mutual fund gains taxable?

Yes. Equity fund gains of over Rs.1.25 lakh in a financial year face 12.5% tax. However, gains of up to Rs. 1.25 lakh are tax-exempt. Gains from debt funds are taxable at the investor’s applicable income slab rate regardless of the holding period.

How are mutual fund returns taxed?

Profits made on selling units are taxed as capital gains. Equity fund gains held for more than 12 months qualify for LTCG. IDCW payouts, if any, are also subject to taxation. They are taxed as dividends as per the investor’s tax slabs.

Can I avoid LTCG tax on mutual funds?

You may not always be able to avoid tax, but you can reduce the tax burden by staying within the exemption limit and practicing tax loss harvesting.

What changed in Budget 2024-25?

The STCG and LTCG rates for equity-oriented mutual funds were increased. STCG was raised from 15% to 20% and LTCG was raised from 10% to 12.5%. However, the exemption limit for LTCG was also raised from Rs. 1 lakh to Rs. 1.25 lakh.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.