Switching from regular to direct mutual funds: Know the hidden tax cost — and when the move actually pays off
Both direct and regular plans of a mutual fund have the same portfolio and are managed by the same fund manager. The key difference is the expense ratio.
Regular plans have higher expenses, which reduce their NAV compared with direct plans. Over time, the lower expense ratio of direct plans can translate into higher returns as the investment compounds.
This often prompts investors to switch from regular to direct plans. But there are hidden tax implications and other factors you must consider.
What is the tax cost of switching from regular to direct plans?
Says Mukesh Kumawat, Executive Director, Anand Rathi Wealth, “Switching from a regular plan to a direct plan of the same mutual fund is treated as redemption of the existing units and a fresh investment in the new plan.”
The same treatment applies when switching from direct to regular plans.
He added that direct and regular plans have different ISINs and are therefore treated as separate investments for tax purposes. The same applies to switches between Growth and IDCW options, as each has a separate ISIN.
“Any capital gains arising on the redemption are taxable in the year of the switch,” Kumawat stated. The tax treatment remains the same whether the switch is made through an investment platform, broker or directly through the AMC.
When can switching have zero tax liability?
Kumawat noted that there are mainly two circumstances:
How to consider the tax impact when switching from regular to direct plans?
Suppose an investor has a lump-sum investment of ₹1 lakh in the regular plan of a large-cap fund. The regular plan has an expense ratio of 1%, compared with 0.5% for the corresponding direct plan.
The investor has remained invested for two years, during which the fund has generated an average annual return of 10% before expenses.
Kumawat explained this as follows:
How can investors decide whether to switch from regular to direct plans?
Kunawat noted that “there are multiple factors to consider, so the decision should not be based only on the expense ratio”.
