There are some investment decisions that we took in the past that we would like to modify now. Switching from a regular plan to a direct plan in an equity mutual fund is one such decision. In this article, we discuss the factors you must consider before you make such a switch.

Tax effect

Mutual funds offer two plans — regular plan and direct plan. Suppose you invest in a large-cap active fund of an asset management company (AMC). If you make the investment through a distributor, you typically invest in a regular plan. When you make the investment directly with the AMC, you invest in a direct plan.

Distributors need incentive to market mutual fund products of an AMC. Therefore, AMCs pay commission to distributors when you invest in a fund and for every year you stay invested in the fund. This commission comes from the fee that an AMC charges you. Hence, the regular plan will carry a higher fee than a direct plan. The portfolio and the fund manager for both direct and regular plans are the same.

What if you want to switch from a regular plan to a direct plan? The process is easy, but you must be mindful of the related cost. This is because your switch is considered as redemption of the regular plan and fresh investment in the same fund through the direct plan.

That would attract capital gains tax. If your redemption involves investments that you have carried for more than 12 months, then you must pay long term capital gains tax at 12.5% if your gains are above ₹1.25 lakh in a year.

For investments with holding period of less than 12 months, you must pay 20% short-term capital gains tax. So, you must consider the tax effect of the switch.

Summing Up

If the amount involved falls within the 1.25 lakh exemption limit for long term capital gains tax, you can consider switching in any year. Suppose the amount exceeds that level or you are required to redeemed other investments during the same year to meet a life goal. In such cases, you must stop the current systematic investment plan (SIP) on the regular plan and start a new SIP on the same fund through the direct plan. You can switch the accumulated investments from the regular plan to the direct plan subsequently when related long-term capital gains tax falls within the annual exemption limit.

(The author offers training programmes for individuals to manage their personal investments)

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