How to Avoid Capital Gains Tax on Mutual Funds

How to Avoid Capital Gains Tax on Mutual Funds?

ByAbhiloans

Mutual funds are the most popular investment choice because they offer diversification, and are managed by experts, and can give you good returns. However, if you’re not careful, mutual funds can also lead to capital gains taxes that eat into your earnings.

Fortunately, there are smart ways to manage and even avoid capital gains tax on mutual funds. In this article, we’ll break it all down in a simple, easy-to-understand way. Let’s dive in.

First, What is Capital Gains Tax?

Whenever you sell a mutual fund unit for more than you paid for it, you earn a profit. That profit is called a capital gain, and the government wants a share of it in the form of capital gains tax.

There are two types of capital gains:

  • Short-Term Capital Gains (STCG): If you sell your equity mutual fund units within one year, any profit you make is classified as short-term and taxed at 15% (plus cess and surcharge).
  • Long-Term Capital Gains (LTCG): If you hold your equity mutual fund units for more than one year, profits up to ₹1 lakh in a financial year are tax-free. Anything above ₹1 lakh is taxed at 10% (without the benefit of indexation).

For debt mutual funds (after April 1, 2023), any gains, regardless of the holding period, are added to your income and taxed according to your income slab rate. Knowing these basics helps you plan your investments better.

Why Do Mutual Funds Trigger Capital Gains Tax Even Without Selling?

Here’s something many investors miss: Mutual funds can distribute capital gains to you even if you haven’t sold any units yourself. This occurs when the fund manager sells investments inside the fund and makes profits. These gains are passed on to you, the investor, usually once a year. That’s why it’s important to pick funds and manage your investments carefully.

Now, How Can You Avoid Capital Gains Tax on Mutual Funds?

Let’s explore practical strategies you can use:

1. Hold Your Investments Longer

The simplest way to minimize taxes is to hold your mutual fund units longer. If you keep your equity mutual fund shares for over a year, you can get tax benefits on the profits you make. Additionally, since gains up to ₹1 lakh are tax-free each financial year, holding longer allows you to use that ₹1 lakh exemption smartly.

Pro Tip: Instead of selling all your units at once, sell a small amount every year to stay within the ₹1 lakh tax-free limit.

2. Use the ₹1 Lakh Exemption Wisely

As mentioned, long-term capital gains up to ₹1 lakh are tax-free. You can plan your redemptions every financial year to take advantage of this. Suppose you have ₹3 lakh of long-term gains.

Instead of redeeming it all at once, you can spread your redemption across three years to keep each year’s gains under ₹1 lakh and pay zero tax. This is called gain harvesting.

3. Opt for a Growth Option Over a Dividend Option

Earlier, mutual funds offered dividend payouts that were tax-free in the hands of investors, but now, dividends are taxed at your applicable slab rate.

By choosing the growth option, the fund does not pay you dividends; instead, the gains are reinvested, helping you defer taxes until you redeem the units.

This not only grows your wealth through compounding but also avoids yearly taxation.

4. Invest Through Systematic Transfer Plans (STP)

Instead of investing a lumpsum directly into an equity fund, consider investing it first into a low-risk debt fund and then systematically transferring a fixed amount every month into the equity fund via STP.

This way:

  • You reduce the risk of investing at a market high.
  • Your equity investments start getting a new holding period, helping you manage when and how you realize gains.

It’s a smart way to invest gradually while managing tax liability.

5. Use Tax-Loss Harvesting

Tax-loss harvesting is a strategy where you intentionally sell investments that are in loss to offset the gains from other investments.

Here’s how it works:

  • If you have made a profit in one fund and a loss in another, you can sell the loss-making fund.
  • The loss can be used to reduce your taxable capital gains.

This is a powerful technique, especially when markets are volatile. If you still want market exposure, you can reinvest in a similar fund (but not exactly the same).

6. Gift Mutual Fund Units to Family Members

Gifting is a lesser-known but effective tax strategy. You can gift mutual fund units to family members, especially those who are in a lower tax bracket.

For example:

  • Gift units to your spouse, parents, or adult children.
  • If they redeem it, the capital gains may either be tax-free (if within exemption limits) or taxed at a lower rate.

However, gifting to your spouse or minor children comes with clubbing provisions under the Income Tax Act, so plan accordingly.

7. Invest in ELSS Funds for Additional Tax Benefits

While Equity-Linked Savings Schemes (ELSS) won’t directly help you avoid capital gains tax, they provide a deduction under Section 80C up to ₹1.5 lakh per year.

Moreover, ELSS funds have a 3-year lock-in, ensuring you qualify for long-term capital gains tax treatment when you sell. It’s a smart way to invest in wealth creation while reducing your taxable income.

8. Choose Index Funds or ETFs

Actively managed funds involve frequent buying and selling of stocks, which can generate internal capital gains distributions. In contrast, index funds and exchange-traded funds (ETFs) have lower turnover. This means they are less likely to trigger taxable events within the fund, helping you minimize capital gains taxes until you choose to sell.

Other Tips to Remember

  • Monitor changes in tax laws regularly because rules regarding mutual fund taxation can change, like what happened with debt funds in 2023.
  • Track the holding period of each mutual fund investment. This will help you determine whether your gains are short-term or long-term.
  • If you have plenty of investments, consult a tax advisor. They can give you personalized advice to improve your investment plan.

Conclusion

Capital gains taxes on mutual funds are an unavoidable reality for most investors, but with smart planning, you can minimize or even completely avoid paying unnecessary taxes.

By holding your investments longer, using your ₹1 lakh exemption smartly, choosing the growth option, harvesting losses, gifting strategically, and opting for tax-efficient funds, you can keep more of your money working for you.

Remember, the goal isn’t just to avoid taxes — it’s to grow your wealth efficiently. A little bit of planning today can make a big difference tomorrow.