How to Avoid LTCG Tax on Mutual Funds?

Before we get into how to avoid it, let’s understand what Long-Term Capital Gains (LTCG) tax actually is. In India, when you invest in a mutual fund and earn a profit by selling it after holding it for a longer duration, that profit is known as a capital gain.

If you hold equity mutual funds for more than one year or debt mutual funds for over two years, the profit is treated as a long-term capital gain (LTCG) and taxed accordingly. For equity mutual funds, any gains exceeding ₹1.25 lakh in a financial year are taxed at 12.5%.

In the case of debt mutual funds purchased before 1st April 2023, long-term capital gains (LTCG) after a holding period of over two years are taxed at 12.5%. However, for debt mutual funds bought on or after 1st April 2023, the gains are taxed as per your income tax slab rates.

Let’s now look at some legal and effective strategies that can help you reduce or even avoid this tax altogether.

1. Use the ₹1.25 Lakh Exemption Every Year

The first ₹1.25 Lakh of LTCG from equity mutual funds is exempt from tax every financial year. This means that you can make long-term gains of up to ₹1.25 Lakh annually and not pay any tax on it.

How to make use of it:

• Track your capital gains throughout the year.
• If your gains are nearing ₹1.25 Lakh, redeem that portion before March 31.
• You can invest again in the next financial year and repeat the process.

This strategy is simple but effective for those with moderate investments.

2. Use Systematic Withdrawal Plan (SWP)

A Systematic Withdrawal Plan (SWP) is a smart way to take money out of your mutual fund investments bit by bit. Instead of withdrawing a large lump sum, which could lead to a big taxable gain, you can set up automatic withdrawals, monthly, quarterly, or even annually.

How SWP helps reduce tax:

When you use an SWP, only a small part of each withdrawal is considered capital gain, and the rest is your original investment (or cost). This means that even if you’re withdrawing, say, ₹20,000 a month, only a fraction of that might count as profit, and that small gain could easily stay within your ₹1.25 lakh LTCG exemption for the year.

Let’s take a simple example. Suppose you invested ₹6 lakhs in an equity mutual fund, and it grows to ₹7.2 lakhs over 3 years. You start an SWP of ₹20,000 a month. In the first few months, most of the money you withdraw is just your capital being returned, and very little is capital gain. This helps you avoid triggering a high LTCG tax bill.

Other benefits of SWPs:

• You don’t have to time the market, withdrawals are automated.
• It can act like a monthly income stream in retirement.
• It gives you the flexibility to plan redemptions across financial years, so you always make the most of the tax-free limit.

Just remember, you should only start an SWP after you’ve held the mutual fund for more than 1 year. That way, any gains from withdrawals qualify as long-term and are eligible for the 12.50% rate and the exemption limit.

So, if you’re nearing retirement or want steady withdrawals without heavy taxes, an SWP could be just what you need.

3. Stagger Your Redemptions

One of the most common mistakes investors make is redeeming all their units in one go. If your mutual fund has appreciated a lot, selling it all at once could mean paying LTCG on the amount exceeding ₹1.25 Lakh.

What to do instead:

• Plan your redemptions in phases.
• Redeem a part in one financial year and the remaining in the next.
• This will help you utilise the ₹1.25 Lakh exemption across multiple years.

Proper planning of redemptions can save you from paying unnecessary tax.

4. Use Tax Loss Harvesting

Tax loss harvesting is a strategy where you sell your losing mutual fund investments to offset the tax on your profitable ones. It might sound a bit negative, selling at a loss, but it can actually help you reduce your overall tax bill quite a bit.

How it works:

Let’s say you made a profit of ₹2 lakhs this year from one mutual fund. But another fund in your portfolio is down ₹80,000. If you sell the loss-making fund, that ₹80,000 loss will be subtracted from your ₹2 lakh profit, leaving you with just ₹1.2 lakh in taxable gains. Now, thanks to the ₹1.25 lakh LTCG exemption, you owe zero tax.

This technique is most useful near the end of the financial year, say in February or March, when you can review your portfolio and sell off poor performers strategically.

Know More About LTCG on Mutual Funds

A few key points to remember:

• Short-term losses can be set off against both long-term and short-term capital gains.
• Long-term losses, however, can only be adjusted against long-term gains.
• If you don’t use all your losses this year, you can carry them forward for up to 8 years, provided you file your income tax return on time.

5. Hold for the Long Term

While the holding period for equity funds to qualify as LTCG is just 1 year, holding them for longer periods like 3 to 5 years not only gives you more growth but also helps with tax planning.

The longer you stay invested:

• The more you benefit from compounding.
• The easier it is to plan redemptions.
• You can spread withdrawals and reduce tax impact.

Patience in investing often leads to better financial and tax outcomes.

Conclusion

If you’ve been wondering how to avoid LTCG tax on mutual funds, you now know that it is entirely possible with some planning and discipline. The Indian tax system does give small investors room to save taxes legally.

To summarise:

• Make the most of the ₹1.25 Lakh exemption.
• Withdraw systematically instead of all at once.
• Invest in ELSS for dual tax benefits.
• Spread investments across family members.
• Use tax loss harvesting to your advantage.
• Time your switches and redemptions carefully.

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