How to Avoid LTCG Tax on Mutual Funds?

Investing in mutual funds yields attractive returns for investors over the long-term. However, such gains can often come with tax implications. When you sell your units after holding them for over a year, a long-term capital gain (LTCG) tax on mutual funds is applicable. While LTCG tax on mutual fund investments is relatively lower compared to short-term taxes, it can still affect your returns. 

If you're wondering how to avoid LTCG tax on mutual funds, here are some smart strategies that can help you optimise your tax outgo while enjoying steady returns on your investment.

What is Capital Gains Tax?

Capital gains are the profits realised from the sale of an asset, such as property, stocks, or bonds, when the selling price exceeds the original purchase price.

There are two types of capital gains-

• Short-term capital gain applies when assets are sold within a short holding period, typically within 12 months. 
• Long-term capital gain occurs when assets are held for a longer period, typically more than 12 months.

How to Avoid Long Term Capital Gains Tax on Mutual Funds in India?

Below are some ways in which you can avoid LTCG tax on mutual funds.

1. Offset Gains with Losses

One of the simplest ways to reduce the LTCG tax on mutual funds is to offset gains with capital losses. If you have mutual fund units or other investments that are currently underperforming, liquidating them can help reduce your net taxable gain.

For example, you earn Rs. 10,000 in capital gains from one fund but face a Rs. 4,000 loss from another investment, selling the loss-making asset will allow you to offset this amount, bringing your taxable gain down to Rs. 6,000. With this strategy, you can lower the taxable amount and improves your portfolio returns.

2. Use a Systematic Withdrawal Plan (SWP)

A Systematic Withdrawal Plan (SWP) allows you to withdraw a fixed amount from your mutual fund investment periodically. By spreading out your redemptions, you can make sure that your gains stay within the LTCG tax exemption limit of Rs. 1.25 lakhs each financial year.

Instead of withdrawing Rs. 5 lakhs in one go (which would trigger LTCG tax), you can set up a SWP to withdraw Rs. 1 lakh per year over 5 years. This can keep your withdrawals mostly tax-free while giving you a regular stream of income.

3. Leverage Tax Harvesting

Tax harvesting in mutual funds is a powerful strategy to reduce long term capital gain tax on mutual funds. This involves selling mutual fund units to realise gains within the tax-free limit every financial year. By selling your units at the right time, you can keep your taxable gains within the Rs. 1.25 lakh exemption limit each year.

How It Works:

• If your mutual fund portfolio has grown by Rs. 2 lakhs, you sell just enough units to book Rs. 1.25 lakhs in gains.
• You then reinvest the proceeds in the same or a different mutual fund, after a short gap to avoid coming under the scanner of the GAAR (General Anti-Avoidance Rule) protocol.
• This strategy can be repeated annually to realise gains tax-free.

By regularly booking gains under the exemption threshold and reinvesting, you avoid accumulating large taxable gains in the future.

4. Invest in Tax-Efficient Mutual Fund Options

Not all mutual funds are created equal in terms of tax efficiency. Some types of funds are designed to minimise tax liabilities. Some tax-efficient options to reduce LTCG on mutual funds include:

• Index Funds: Since these funds are managed passively, they have relatively lower turnover and subsequently lower taxable gains compared to actively managed funds.
• Exchange-Traded Funds (ETFs): These are structured to minimise capital gains distributions, making them a smart tax-efficient choice.
• ELSS (Equity Linked Savings Schemes): Though they are subject to LTCG tax, they offer deductions of up to Rs. 1.5 lakhs under Section 80C, reducing your overall taxable income.

Choosing these funds can help you grow wealth while keeping your tax liability under control.

5. Hold Investments for the Long Term

Frequently buying and selling of mutual fund units results in multiple taxable events. But when you hold your investments for longer durations, you reduce LTCG on mutual funds and benefit from compounding.

• Short-Term Capital Gains (STCG) on equity funds are taxed at 15% if held for less than 12 months.
• LTCG is taxed at 10% (plus cess) only if gains exceed Rs. 1.25 lakhs annually.

Benefits of long-term holding:

• Higher returns due to compounding.
• Fewer transactions mean fewer taxes.
• Maximises tax exemptions and investment efficiency.

6. Gifting Mutual Fund Units to Family Members

Finally, you can gift mutual fund units to family members in lower tax brackets to reduce your overall tax burden. Since gifts to immediate family members are not taxed in India, you can use this approach if you’re wondering how to avoid LTCG tax on mutual funds. 

How It Works:

If you're in the 30% tax slab, but your retired parent or adult child is in the 5% bracket, transferring units to them allows the capital gains to be taxed at their lower rate.

However, if you gift the units to your spouse or a minor child, the income thus generated will be clubbed with your income under Section 64, limiting the tax-saving benefit. But gifting to parents or adult children can significantly reduce the tax outgo.

To know other ways on how to avoid tax on mutual funds, consulting a financial advisor is advisable. They can help maintain compliance with tax regulations while maximising potential savings. To begin your investment journey and work towards your financial goals, download the Tata Capital Moneyfy app today.