How to Avoid Capital Gains Tax in Mutual Funds (2024)

In the Union Budget 2018, the late Finance Minister Mr. Arun Jaitley reintroduced a long-term capital gains tax on equity investments. As a result, the returns on Before this, Capital Gains from Equity investments were tax-free if the investment had been held for a year or longer before being redeemed.

While the gains from mutual funds are currently taxable, there is a strategy using which you can legally reduce the Capital Gains Tax applies to your investment returns even though you might not be able to avoid taxes completely. The method is known as Tax Harvesting.

In the subsequent sections, we will discuss how Capital Gains Taxation of Mutual Funds works and how using tax harvesting and tax loss harvesting, you can reduce the tax burden on your investment returns.

1. How is Capital Gains Tax on Mutual Funds Calculated?

To better understand how you can reduce your Capital Gains Tax burden, you first need to know how the taxation of mutual funds works. There is a difference between how Debt-oriented Mutual Funds and Equity-oriented Mutual Funds are taxed. The details of Capital Gains Tax rules for Debt and Equity investments are like this:

• Taxation of Debt-Oriented Mutual Funds:In the case of Debt Mutual Funds, gains from fund units that are held for 3 years or less before being redeemed are classified as Short Term Capital Gains (STCG) and taxed as per your slab rate. So, the Short Term Capital Gains Tax payable in the case of Debt Funds can be as high as 30%.

  Gains from Debt Fund units that are held for over 3 years before being redeemed qualify for the Long Term Capital Gains (LTCG) tax rate.
  For investments made in debt funds before 01 April 2023, the 20% long-term capital gains tax is applicable with indexation benefit.
  However, according to Budget 2023, gains on any investment made in a debt fund after 01 April 2023 will be taxed as per your income tax slab. Also, there won’t be any indexation benefit.

• Taxation of Equity-Oriented Mutual Funds:In the case of Equity Funds, if you hold the fund units for up to 1 year before redeeming, your gains will be classified as Short Term Capital Gains (STCG). The STCG Tax rate of 15% will be applicable to your gains. On the other hand, if you have held your Equity Fund units for over 1 year before redeeming, you have to pay Long Term Capital Gains (LTCG) tax,,, on your gains.
  The LTCG tax rate for Equity Mutual Funds is 10% of gains in excess of Rs. 1 lakh in a financial year. So, in case your total Equity Gains are Rs. 1.1 lakh in a financial year, the 10% tax is applicable only on Rs. 10,000 while the remaining Rs. 1 lakh of gains is tax-free.

2. Is there a Way to Reduce Capital Gains Tax on Short Term Gains?

In the case of both Equity and Debt Mutual Funds, there is currently no way to reduce the Capital Gains Tax applied to your short-term returns. So you have to pay Capital Gains Tax as per your slab rate in case you book short-term gains from Debt Funds.

Similarly, short-term gains on Equity Funds are also taxable. So if you redeem your Equity investments before completing 1 year, you will have to pay a 15% Capital Gains Tax on your returns.

3. How to Reduce Long-Term Capital Gains Tax on Mutual Fund Returns?

In the case of Debt Mutual Funds, your Long Term Capital Gains automatically qualify for the indexation benefit. This automatically reduces your tax burden. So all you need to do is stay invested in a Debt Fund for 3 years or longer and the indexation benefit will be applicable to your redemptions.

In the case of Equity Mutual funds, long-term capital gains (LTCG) are taxable only if your returns in a financial year exceed Rs. 1 lakh. So if your Long-Term Capital Gains from Equity Mutual Funds are less than or equal to Rs. 1 lakh in a financial year, you do not have to pay any Capital Gains Tax on your returns. This is the basis of the Tax Harvesting strategy in Equity Mutual Funds.

4. How Tax Harvesting Helps Reduce Capital Gains Tax

In case you have invested only a small amount so far, your long-term returns from the investment will be less than Rs. 1 lakh. So, you will not have to pay any long-term capital gains tax on redemption. But, as you keep adding to your investments and your returns keep growing, your returns will exceed the Rs. 1 lakh mark and become taxable.

The below table shows how soon your returns will exceed the Rs. 1 lakh mark in case of different lump-sum investment amounts assuming annual returns of 12% p.a. on your investments:

As you can see, for a lump sum investment of Rs. 1 lakh, your Long-Term Capital Gains will exceed the Rs. 1 lakh threshold after 5 years. But the larger lumpsum investment of Rs.2.5 lakh, the time taken for your long-term gains to exceed Rs. 1 lakh is only 3 years.

Tax Harvestingis the strategy of selling some of your Equity Mutual Fund units every year to book long-term gains and then reinvesting the proceeds into the same fund.

To better understand how this works, let’s take an example. Suppose you invested Rs. 6 lakh in an Equity Fund on 1st February 2020 and received 12% returns on your investment. Now on 1st March 2021, your investment returns and capital gains will look something like this:

Now if you redeem your investments on 1st March 2021, you won’t have to pay any Capital Gains Tax because the gains are Rs. 75,305 and gains up to Rs. 1 lakh in a financial year are tax-free.

Next, you will have to reinvest the proceeds into the same scheme. On investing the proceeds i.e. Rs. 6.75 lakh on 2nd March 2021 and assuming returns of 12% p.a. on your investment, your investment will grow to something like this by 5th March 2022

Now you again redeem your investments. Since they have completed one year, the returns will be classified as Long Term Capital Gains. However, you won’t pay any tax because the capital gains of Rs. 84,718 is less than the Rs. 1 lakh limit of the financial year.

Now, consider a case where instead of redeeming your investment in March 2021, you stayed invested and let your Rs. 6 lakh initial investment grow till 5th March 2022.

As you can see, by using tax harvesting, you avoided paying Capital Gains Tax on your Mutual Fund investments.

Tax Harvesting will also work when you take the SIP route to invest. All you have to do is redeem units that qualify for long-term capital gains i.e. have been held for 12 months or more and reinvest the proceeds every time.

5. Tax Loss Harvesting: How to Use Capital Losses to Reduce Capital Gains Tax

In the case of Tax Loss Harvesting, you book Long-Term Capital Losses and offset those losses against Long-Term Capital Gains from other investments to reduce your Capital Gains Tax burden.

To understand how Tax Loss Harvesting works better, let’s take an example. Suppose you have invested Rs. 2 lakh in an Equity Mutual Fund on 1st Feb 2020. If the value of your investment decreases to Rs. 1.6 lakh as of 3rd March 2021, your Capital Loss on redemption will be like this:

This Long-Term Capital Loss can now be offset against any Long-Term Capital Gains you might book in the same year or carry forward the loss for the next 8 assessment years.

Now, suppose you had received long-term capital gains of Rs. 1.42 lakh from another equity fund in January 2021. You can offset these gains with the losses. So the tax payable will be something like this.

As you can see, by offsetting your Capital Loss against Capital Gains in the same year, you can significantly reduce the Capital Gains Tax payable. This is how tax-loss harvesting can be used to reduce the tax on Mutual Fund redemptions.

Now, suppose you didn’t have any capital gains in 2021. But 2 years later, in March 2023, you make Long-term Capital Gains of Rs. 1.5 lakh on your investment. You can offset these gains with the loss you incurred in 2021 to reduce your tax liability.

As you can see, by offsetting your Long-Term Capital Gains against Long-Term Capital Losses from the previous year, your taxable gains were reduced. This decreased the Capital Gains Tax that was payable on your investment.

Tax harvesting is a simple and effective strategy that you can use to reduce the Capital Gains Tax on Equity Mutual Fund returns. But you do need to keep one thing in mind. Tax harvesting works only if you reinvest your redemption proceeds. If you fail to reinvest, you will be able to avoid some Capital Gains Tax in the short term. But failure to reinvest will adversely impact your ability to reach long-term investment goals.

6. Frequently Asked Questions (FAQs)