How to Avoid Long-Term Capital Gains (LTCG) Tax on Mutual Funds

Investing in mutual funds is a popular way to grow wealth over the long term. However, the gains from these investments can be subject to Long-Term Capital Gains (LTCG) tax. In India, how to avoid LTCG tax on mutual funds was reintroduced in the 2018 budget, and understanding how to minimize or avoid this tax can significantly enhance your investment returns. This article will explore various strategies to avoid or reduce LTCG tax on mutual funds.

Understanding LTCG Tax on Mutual Funds

Before delving into the strategies, it is essential to understand the basics of LTCG tax on mutual funds:

• Equity Mutual Funds: These funds invest primarily in stocks. Gains from these funds are considered long-term if held for more than one year. The LTCG tax rate on equity mutual funds is 10% for gains exceeding ₹1 lakh in a financial year, without the benefit of indexation.
• Debt Mutual Funds: These funds invest in fixed-income securities. Gains from debt mutual funds are considered long-term if held for more than three years. The LTCG tax rate on debt mutual funds is 20% with the benefit of indexation.

Strategies to Avoid or Reduce LTCG Tax on Mutual Funds

1. Utilize the ₹1 Lakh Exemption

For equity mutual funds, LTCG up to ₹1 lakh in a financial year is exempt from tax. Investors can plan their redemptions strategically to make use of this exemption every year.

How to Implement:

• Systematic Withdrawal Plan (SWP): Set up an SWP to withdraw gains systematically in a way that total gains in a financial year do not exceed ₹1 lakh.
• Partial Redemptions: Instead of redeeming your entire investment at once, consider redeeming parts of it spread over multiple financial years to stay within the ₹1 lakh exemption limit each year.

2. Tax Harvesting

Tax harvesting involves selling mutual fund units when the gains are just below or slightly above ₹1 lakh and then reinvesting the proceeds. This allows you to reset the purchase price (cost basis) of your mutual fund units, effectively utilizing the ₹1 lakh exemption annually.

How to Implement:

• Sell mutual fund units to book gains up to ₹1 lakh.
• Immediately reinvest the proceeds to purchase the same or different mutual fund units.
• This strategy can be repeated each financial year to benefit from the ₹1 lakh exemption.

3. Investing Through Family Members

You can spread your investments across family members to take advantage of their individual ₹1 lakh exemption limit.

How to Implement:

• Gift money to your spouse, children, or parents (who fall in a lower tax bracket) and invest in mutual funds in their names.
• Each family member can utilize their ₹1 lakh LTCG exemption, thereby increasing the total tax-free gains for the family.

4. Strategic Investment in Debt Funds

For debt mutual funds, the LTCG tax benefits from indexation can significantly reduce the taxable gains. Indexation adjusts the purchase price for inflation, reducing the capital gains.

How to Implement:

• Hold debt mutual funds for more than three years to qualify for long-term capital gains.
• Use indexation to reduce the taxable gains. The longer you hold the investment, the higher the inflation adjustment, thereby lowering the tax liability.

5. Invest in Tax-Efficient Funds

Certain mutual funds are designed to be more tax-efficient, such as Equity Linked Savings Schemes (ELSS) and balanced or hybrid funds.

How to Implement:

• ELSS Funds: These funds offer tax benefits under Section 80C of the Income Tax Act, allowing you to claim a deduction of up to ₹1.5 lakh. While ELSS funds have a lock-in period of three years, the LTCG beyond ₹1 lakh is still taxable, but the upfront tax deduction can offset some of the tax burdens.
• Balanced Funds: These funds invest in both equity and debt, offering a balanced approach. The equity component may still benefit from the ₹1 lakh exemption.

6. Avail of Deductions and Exemptions

You can offset your LTCG against any available deductions and exemptions to reduce the taxable amount.

How to Implement:

• Utilize losses from other investments to offset your gains. For example, if you have incurred short-term or long-term capital losses from other investments, these can be set off against your LTCG from mutual funds.
• Reinvest your gains in specified tax-saving instruments like the National Pension Scheme (NPS) to avail of additional deductions under Section 80CCD(1B).

7. Invest in Direct Plans

Direct plans of mutual funds have lower expense ratios compared to regular plans, leading to higher returns. Higher returns mean that even after paying LTCG tax, you could end up with better net returns.

How to Implement:

• Choose direct plans over regular plans when investing in mutual funds.
• The reduced expense ratio leads to higher compounded returns over time, which can help offset the tax impact.