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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 minimise the amount of tax that they pay. This article tells you more about how mutual funds are taxed and strategies to reduce tax outgo.

Table of contents

What is long-term capital gains tax on mutual funds?
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
What is the impact of economic trends on long-term capital gains?
Common mistakes to avoid when planning LTCG tax on mutual funds

What is long-term capital gains tax on mutual funds?

Long-term capital gains tax on mutual funds is simply the tax you pay if you earn profits on selling your mutual fund units after holding them for a specified period. Typically, long-term capital gains tax is lower than short-term capital gains tax. This encourages investors to hold their investments for a longer period.

For equity-oriented mutual funds (investing at least 65% of its portfolio in domestic equities), units held for more than 12 months (i.e., a year) are considered long-term investments from a taxation perspective.

For mutual funds that invest more than 35% but less than 65% in equities, a holding period of two years or more is considered long term for taxation purposes.

For debt mutual funds, capital gains on all units purchased after April 1, 2023, will be deemed short-term capital gains and long-term capital gains tax benefit will no longer apply. This change was announced in the 2023 union Budget, before which units in debt funds held for more than 36 months qualified for long-term 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)
- Taxed 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.

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 tax 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 -
- Deduction under Section 80C of the Income Tax Act, 1961 (only applicable to those who have opted for the old tax regime).
- 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.

What is the impact of economic trends on long-term capital gains?

Rate of inflation: Inflation can silently erode wealth as it can diminish the purchasing power of capital over time, thereby reducing the actual value of gains realised by investors. To mitigate this adverse effect, investors can seek avenues offering returns that have the potential to beat the inflation rate.
Economic growth: It is easy to see how the economy impacts long-term capital gains. Robust economic growth typically correlates with favourable conditions for long-term capital appreciation because businesses thrive, consumer spending increases and investor confidence soars. This increases asset prices and boosts long-term capital gains on mutual funds. On the other hand, economic slowdowns may trigger market volatility that may pose challenges for long-term wealth creation.
Government policies: The introduction of new government policies or modification of old ones can have considerable influence over the taxation framework governing long-term capital gains. For instance, the scrapping of favourable taxation on long-term capital gains from debt funds in 2023 affected the real returns and investment strategies of many investors in India.

Common mistakes to avoid when planning LTCG tax on mutual funds

Here are a few common mistakes you need to avoid when preparing to pay capital gains tax.

Redeeming your units before the completion of the minimum holding period. The holding period depends on the type of scheme. Equity-oriented funds qualify for long-term capital gains tax if held for more than a year, while gains from debt funds are deemed to be short-term capital gains regardless of the holding period.
Not keeping a proper record of the purchase and redemption dates of your units for the accurate calculation of your long-term capital gains tax.
Not planning around the exemption limit. For equity-oriented funds, LTCG of up to Rs. 1.25 lakh in a financial year are tax-exempt. Investors can plan their redemptions such that they stay below or close to this limit to reduce their tax liability.
Ignoring SIP-specific holding period. Each SIP installment has its own purchase date and its holding period is determined accordingly. Redeeming too many units may trigger STCG on some of the units.

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.

What are capital gains in mutual funds?

There's a capital gain in a mutual fund scheme whenever the price of its units increases. Mutual fund capital gains are often subject to investor taxation.

Is it a good idea to invest in mutual funds when preparing for retirement?

Mutual fund investing may be recommended as a viable strategy for saving for retirement. Through a Systematic Investment Plan (SIP), you can invest in mutual funds. With an SIP, you can invest in the mutual fund scheme of your choice based on your investment requirements and risk tolerance. To predict the future value of your investment, you can also utilise an online SIP calculator.

How does the economy impact long-term capital gains?

When the economy is on a growth trajectory, businesses thrive and consumer spending increases. Investor confidence also soars, resulting in bullish trends in equity markets. This drives up asset prices and can potentially lead to an increase in long-term capital gains on mutual funds and other investments.

How do inflation rates impact long-term capital gains?

Inflation reduces the purchasing power of money over time, meaning that while investments may earn returns, their real value could be lower. To assess the actual increase in wealth, it's important to account for inflation when evaluating long-term capital gains. If returns do not exceed inflation, an investor’s actual purchasing power may not increase.

What role does GDP growth play in capital appreciation?

GDP growth indicates economic expansion and can contribute to capital appreciation by boosting corporate earnings, investor confidence, and demand for assets like stocks and real estate. However, while strong GDP growth can be beneficial, capital appreciation is also influenced by other economic and market dynamics.

How do government policies affect long-term capital gains tax?

Tax regulations set by the government determine how long-term capital gains are taxed. Changes in tax rates, holding periods, or indexation benefits can affect the final tax liability on investment gains. Staying informed about tax policies and consulting a tax advisor is advisable, as these regulations may change over time.

Can global economic trends influence mutual fund returns in India?

Global economic trends play a crucial role in shaping mutual fund returns in India. Factors such as global economic growth, interest rate movements in major economies, fluctuations in commodity prices (especially oil), and changes in international trade policies influence investor sentiment and capital inflows. These elements can affect Indian stock markets and contribute to market volatility, particularly in emerging markets like India.

What are the some investment strategies to optimise long-term gains?

There is no single strategy that increases gains, but certain approaches can potentially be beneficial. Investing consistently, maintaining a diversified portfolio across asset classes, staying invested for extended periods, and periodically reviewing investments are considered prudent. However, market conditions fluctuate, and no strategy is fool-proof. Returns are not guaranteed and depend on market conditions.

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