How taxation plays a role when switching to direct funds – Find out

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April 2, 2021 4:27 PM

Investors need to play it smart when they are deciding to switch from regular to direct funds. It is advisable not to make early exits from the regular plan as exit load.

Mutual funds, Mutual funds queries, Mutual funds industry, Mutual funds investment news, mutual fund investment, regular plans, direct plans, financial planning, intelligent tips on financial planning, New Year, 2021, investment portfolio, debt repayment plan, credit score, emergency fund, Stock, stock market investment,, asset allocation, asset allocation strategy, rebalancing portfolio, asset mix, mutual funds, asset classes, equity, debt, cash equivalents, SIP, Biggest money lessons of 2020, money lessons of 2020, Financial emergency, diversification, investing, Covid-19, equity market, SIP, Mutual Fund, MF, mutual fund investment, smart strategies to optimize mutual fund returns, direct plans, regular plans, direct plans, regular plans, Mutual Fund, MF, mutual fund investment,The best part is as an existing investor, you can also switch your existing regular mutual funds to direct plans.

Investing in mutual funds has gained traction in the last few years. However, the total penetration of mutual funds in India is still low especially due to a lack of financial awareness and literacy among investors.

To start with, one needs to have proper knowledge of mutual funds before starting to invest. For instance, even though direct plans of any mutual fund scheme are widely suggested now, one needs to be extremely cautious before jumping onto them. If you want to invest directly, you need to have a good grasp of investing and an understanding of the various objectives of investment.

With regular plans, intermediaries like brokers, distributors or banks work as the middle man between the investor and the AMC (Asset Management Company) and charge commission or brokerage to provide the services. Direct plans, as the name suggests, lets the investor invest directly with the AMC or the fund house. There is no involvement of third party brokers or distributors or banks. Hence, there is no commission or brokerage involved.

The best part is as an existing investor, you can also switch your existing regular mutual funds to direct plans. However, keep in mind that they will be taxed differently.

Here is how taxation plays a role when switching to direct funds;

Switching from the regular fund to the direct fund of the same mutual fund scheme results in the redemption of the units an investor holds of the regular fund. Archit Gupta, Founder and CEO, ClearTax says, “An investor will have to buy the units of the direct fund after redemption of the units of a regular fund, as there is no ‘transfer’ of the units happening between the schemes. As an investor redeems their investments in the regular fund, they will essentially attract taxes.”

For instance, with equity-oriented funds, if your holding period is shorter than 1 year, you will have to pay short-term capital gains tax (STCG) at 15 per cent. In case of the holding period exceeding 1 year, you will attract long-term capital gains tax (LTCG) at 10 per cent if the gains are in excess of Rs 1 lakh a year, and there is no benefit of indexation provided. Note that, you will also have to pay the applicable cess and surcharge on your capital gains.

In the case of debt funds, your capital gains will be termed ‘short-term’ if your holding period is shorter than 3 years. These gains are then added to your overall income and taxed at your income tax slab rate. You realise long-term capital gains if the holding period is longer than 3 years. These gains are taxed at 20 per cent after indexation. As an investor, you will also have to pay the applicable cess and surcharge.

Apart from the tax on capital gains, an investor will also have to pay the securities transaction tax (STT) on buying and selling equity fund units. They will also be needed to pay stamp duty on the purchase of new units of the direct fund at 0.005 per cent. Gupta says, “Investors may also have to bear the exit load on early withdrawals. One should keep all taxes and charges in mind before deciding to switch from regular to direct funds.”

He further adds, “There is no doubt that the returns offered by direct funds are slightly higher than regular funds as there are no commissions or third-party charges involved. However, switching to direct funds may come at a considerable cost. The slightly higher return you are going to earn may be negated by the associated costs.”

What are the dos and don’ts for investors?

Industry experts say, investors need to play it smart when they are deciding to switch from regular to direct funds. It is advisable not to make early exits from the regular plan as exit load (depending on the fund plan) could be charged.

Gupta says, “One may consider switching to direct funds only if he/she is sure that the associated costs of switching with slightly higher returns from direct funds will be recovered. If one’s investment horizon is shorter, it would not be a wise move to switch as the cost of switching will be higher and it is unlikely that the gains will be significantly higher than the cost of switching.”

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