Introduction

The long-term capital gains (LTCG) tax is applied to selling units purchased through a mutual fund. Equity-oriented mutual funds held for more than 12 months are classified as long-term. Other fund categories (debt, hybrid fund) have varying holding-period rules and should be specified. In this article, you will understand why LTCG planning is essential and how to avoid LTCG tax on Mutual funds.

Why is LTCG Tax Planning Important?

According to Section 112A, returns from the long-term capital gain arising from the transfer of listed equity shares and equity-oriented mutual fund units (provided they are long-term capital assets) will be subject to tax at the rate of 12.5% on gains exceeding ₹1.25 lakh (₹125,000) in each financial year. (This rule has been revised effective 23 July 2024). Whereas the taxation of debt mutual funds depends on whether you purchased them before or after April 1, 2023: If you acquired them before April 1, 2023, any gain from selling units held for more than 36 months will be considered long-term. This means (a) it will be taxed at 20% and (b) you are entitled to indexation. If you purchased a debt mutual fund after April 1, 2023, and have the financial means to wait, the entire gain will be taxed at your slab rate, regardless of how long the unit was owned (often at your income slab rate). This means the long-standing notion of a long capital gain tax does not exist for debt mutual funds. With some innovative strategies, you can lower or eliminate taxes from LTCG on mutual funds and indirectly keep more of your wealth.

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Some innovative strategies to minimise LTCG taxes

1. Take Advantage of Tax Harvesting

Tax harvesting is a great way to avoid long-term capital gains taxes on mutual funds. You will operate based on selling out units to realise capital gains up to the ₹1.25 lakh tax-free amount allowed for equity funds and then reinvest in a similar or identical scheme. Doing this will reset your cost basis; hence deferring higher tax amounts owed. For example, suppose your portfolio shows a capital gain of ₹2 lakh. In that case, we will sell a portion of your units to recognise ₹1.25 lakh tax-free, reinvest the proceeds, and then sell off the remaining units over the next year or two per the anti-avoidance rules so that your sale seems legitimate each year. This technique can also be utilised for mutual funds with hybrid structures so that you can mitigate long-term capital gains.

2. Select Tax-Efficient Funds

You can proactively reduce your tax event by selecting the right funds. For example, Equity-Linked Savings Schemes (ELSS) allow for an Indian tax deduction of ₹1.5 lakh under 80C application (Only in old tax regime). ELSS funds qualify for long-term capital gains tax, similar to equity funds, but require a three-year lock-in period. Index funds and exchange-traded funds (ETFs) are also tax-efficient vehicles thanks to their low turnover rate of the underlying portfolio, which minimises any capital gains distributions along the way. By using index funds or ETFs, you're reducing your exposure to heightened LTCG tax in the future while increasing your portfolio.

3. Time Your Investments

An easy way to avoid the LTCG tax trap is to hold onto your investments longer. Specifically, if you hold equity funds for over a year, LTCG will be taxed 12.5%, compared to 20% for short-term gains (revised effective 23 July 2024).  The whole idea of this buy-and-hold philosophy is to optimise for compounding tax-deferred earnings until you cash out your investments. For all Debt funds purchased before April 2023, hold for more than 36 months to qualify for a long-term capital gain subject to tax at 20% with indexation, as opposed to a rate based on your slab for less than 36 months.

4. Use Systematic Withdrawal Plans (SWPs)

Systematic Withdrawal Plans (SWPs) enable you to make regular withdrawals of a fixed amount and will allow you to keep your gains within the ₹1.25 lakh tax-free allowance for equity funds. For illustration, instead of redeeming ₹5 lakh all at once, take out ₹1 lakh per year for five years; this will minimise LTCG tax payables, and possibly eliminate the tax. Furthermore, this provides a regular income stream, which works well for retired investors, so you are not giving up tax efficiency in LTCG on equity mutual funds. If you purchased the units before April 1, 2023, and held these units for greater than 36 months, you will owe tax on these units as a Long-Term Capital Gains tax (LTCG) at the rate of 20%, with indexation. If you purchased the units on or after April 1, 2023, you would owe tax at your applicable income tax slab rate for the relevant income, regardless of how long the units are held.

5. Gift Units to Family Members

Gifting units to family members at a lower tax rate will also assist in managing LTCG exposure, as gains will then be taxed in their hands. However, under tax rules, gifts to a spouse or a minor child may also be included in your income. Still, upon sale, they are taxed at the lower income bracket of the family member. Remember that any amounts gifted to your spouse or minors may be clubbed against earnings.

Conclusion

Understanding how to avoid LTCG tax is doable, and solely locking in these strategies should be done alongside your personal financial goals. Harvesting the type of fund (long-settlement), length of holding, the timing of systematic withdrawal plans, and gifting are all methods that alleviate the tax on LTCG on mutual funds. Talk to a tax advisor to adapt these approaches and stay informed on the rules, like those from Budget 2024. When you plan well, you can grow wealth more efficiently and keep more of your mutual fund returns in India.

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