Shifting From Equity To Debt Mutual Funds? Understand Tax Implications, Alternatives

Newbie investors sometimes may invest in an equity fund and a debt fund contemplating switching between mutual funds to deal with volatility. However, they will encounter tax implications that often affect their returns adversely.

Expenses To Be Incurred While Switching

Exiting a fund within one year typically incurs an exit load of around 1 per cent, an important factor to consider before switching between funds. Switching can be between funds in the same house or to a fund in another fund house but exit load will apply.

In either case, switching investments will also incur tax liabilities. Switching out of equity funds results in gains getting taxed similar to equities. Even if the new scheme is from the same fund house, the investor has to pay the capital gains tax.

Ajay Pruthi, a Securities and Exchange Board of India (Sebi) registered investment advisor and founder of PLNR outlined the tax structure saying, "Short-term capital gains are taxed at 15 per cent, i.e., if the investment is less than 1 year. Long-term capital gains are taxed at 10 per cent on gains above Rs 1 Lakh. No tax is applicable for gains up to Rs 1 Lakh on long-term units."

"The period is calculated from the date of investments for every SIP. The tax liabilities would be the same for both switching and withdrawal,” Pruthi added.

Hybrid Funds: A Tax Efficient Alternative

Here in the above-mentioned case, switching from equity to debt funds resulted in gains getting taxed. Further again gains are taxed at higher rates in debt funds. After the Finance Act 2023, the sale of a debt mutual fund will attract a slab rate of taxation that can be up to 30 per cent, if the holding period is less than three years.

Avinash Luthria, Sebi RIA at Fiduciaries said, “For those who are using separate equity and non-equity MFs, rebalancing via redemptions should be avoided because it causes unnecessary taxation.”

Hybrid funds, a diversified investment blend of stocks, bonds, and other assets, offer a tax-efficient alternative and also can prevent the need for continuous rebalancing. Following the 2023 budget, holding hybrid funds is better for tax efficiency purposes as they are considered like holding an equity fund. For example for conservative investors who tend to shift from equity to debt, for a considerable allocation in debt, a balanced hybrid fund is a good choice.

Luthria added, “Balanced Hybrid (i.e. 40 - 60% equity) should not be confused with Balanced Advantage (i.e. Dynamic Asset Allocation with 0 - 100% equity). Balanced Hybrid is subject to LTCG tax of 20 per cent with indexation benefit, making it a very tax efficient category that investors should consider compared to debt funds. 

In conclusion, understanding tax implications is crucial when switching between mutual funds. Also, explore different types of hybrid funds, and choose one with an allocative pattern suited to your risk tolerance. Hybrid funds are a tax-efficient alternative that can help you avoid constant rebalancing or switching between funds.