According to Mukesh Kumawat, Executive Director at Anand Rathi Wealth, switching between regular and direct mutual fund plans is treated as redemption of existing units and fresh investment in the new plan. Both direct and regular plans have different ISINs and are treated as separate investments for tax purposes. Any capital gains arising on redemption are taxable in the year of the switch, with the same tax treatment applying regardless of whether the switch is made through an investment platform, broker, or directly through the AMC. The same applies to switches between Growth and IDCW options, as each has a separate ISIN.
As reported by Mint, there are two main circumstances where switching has zero tax liability. Kumawat noted that if the fund has delivered zero or negative returns at the time of switching, there is no capital gain and therefore no tax. Additionally, if equity fund units have been held for more than 12 months and total long-term capital gains from all equity investments during the financial year are within the ₹1.25 lakh exemption, there is no tax liability on the switch.
According to the analysis provided by Anand Rathi Wealth, consider an investor with a ₹1 lakh lump-sum investment in a large-cap fund's regular plan with a 1% expense ratio versus a direct plan with 0.5% expense ratio. After two years of 10% average annual returns before expenses, the regular plan would earn approximately ₹1.19 lakh while the direct plan would generate ₹1.27 lakh. With a tax liability of around ₹2,350 on the switch, the net amount available for investing in the direct plan would be ₹1.16 lakh. The direct plan would require 4-5 years after the switch to make up for the initial tax outgo and catch up with the regular plan. As per Mint, assuming a 10% pre-expense return, the regular plan would earn about 9% and the direct plan 9.5% annually. After two years, the regular plan would have generated approximately ₹1.19 lakh with LTCG of around ₹18,800, taxable at 12.5% to create a tax liability of ₹2,350.
As reported by Mint, Kumawat emphasized that multiple factors should be considered beyond expense ratios when deciding to switch. Investors should check the fund's year-on-year performance and alpha consistency, assess whether the regular plan's distributor adds value through fund selection and investment discipline, and calculate capital gains, applicable tax, and whether the ₹1.25 lakh LTCG exemption has been exhausted elsewhere. The decision should also compare the post-tax amount moving to the direct plan with annual savings from the lower expense ratio, considering the FIFO rule for SIP investments and any applicable exit loads. If the remaining horizon exceeds the breakeven period, switching may be financially beneficial. Otherwise, it may not make sense.
