Capital Gains Tax on Switching to Direct Mutual Funds: Worth It or Not?

The case for switching to direct mutual funds is strong: lower expense ratios, no hidden commissions, and better long-term returns. But one concern holds many investors back—capital gains tax.

“Why pay tax on something that’s already working?” they ask. While it’s a valid question, the answer often lies in doing the math and understanding how taxation works.

Let’s decode it.

What Happens When You Switch?

Switching from a regular to a direct plan is treated by the Income Tax Department as a sale of your existing fund (redemption) followed by a fresh investment in the direct plan. This triggers capital gains tax based on:

• The type of fund (equity or debt)
  
• The holding period (short-term or long-term)
  
  

Tax Rules for Equity Mutual Funds

Equity-oriented mutual funds are taxed as follows:

• Short-Term Capital Gains (STCG):
  
  
  • Holding period: Less than 12 months
    
  • Tax rate: 15% on gains
    
    
• Long-Term Capital Gains (LTCG):
  
  
  • Holding period: More than 12 months
    
  • Tax rate: 10% on gains exceeding ₹1 lakh per year
    
  • Example: If your gain is ₹1.5 lakh, only ₹50,000 is taxed at 10%.
    
    

In many cases, if your gain is under ₹1 lakh, you pay no tax at all.

Tax Rules for Debt Mutual Funds

Debt mutual funds follow a different set of rules, especially after changes made in 2023.

• Short-Term Capital Gains (STCG):
  
  
  • Holding period: Less than 36 months
    
  • Tax rate: As per your income tax slab
    
    
• Long-Term Capital Gains (LTCG)
  (For funds purchased before April 1, 2023)
  
  
  • Holding period: More than 36 months
    
  • Tax rate: 20% with indexation benefit
    
  • Indexation adjusts your cost for inflation, reducing taxable gain.
    
    

From April 1, 2023, all gains from debt funds (regardless of holding period) are taxed as per income slab, removing indexation.

Why Tax Fear Is Often Overstated

Let’s assume you invested ₹10 lakhs in an equity regular mutual fund 5 years ago, and it’s grown to ₹17 lakhs.

• Capital gain: ₹7 lakhs
  
• LTCG exemption: ₹1 lakh
  
• Taxable gain: ₹6 lakhs
  
• Tax @10%: ₹60,000
  
  

Now let’s compare that with the benefit of switching:

• Regular Plan (2% expense) @10% net return → ₹17L becomes ₹73.5L in 15 years
  
• Direct Plan (1% expense) @11% net return → ₹17L becomes ₹83.1L
  
• Difference: ₹9.6 lakhs gained
  
• Even after ₹60,000 in tax, net gain = ₹9 lakhs+
  
  

That’s a small price for a large reward.

Common Investor Fears (and Facts)

• “Switching is complicated.”
  Most platforms now offer online switching. It’s easier than it sounds.
  
  
• “I’ll lose my SIP track record.”
  Your new direct SIP will start fresh, but your wealth creation won’t slow down.
  
  
• “Tax will eat my gains.”
  Only the gains are taxed, and in most long-term cases, the impact is far less than the benefit of compounding in a direct plan.