Is switching from regular to direct mutual funds profitable despite the tax burden? Explained

The direct plan of a mutual fund scheme is cheaper than its regular plan due to its lower expense ratio. For a long-term investor, the difference in the expense ratios between direct and regular plans can lead to a significant gap in the final corpus. Yet many investors are often hesitant to switch from regular to direct plans, even when they aim to remain invested for a long time. One reason that holds them back is the fear of tax leakage.

When you switch from a regular to a direct plan of an equity mutual fund scheme, you essentially sell your regular units and buy new units under the direct plan. This can lead to a tax liability, calculated at 12.5% of the long-term gains over ₹1.25 lakh or 20% of short-term gains, as the case may be.

For example, suppose an investor has total long-term capital gains (LTCG) of ₹50 lakh from regular mutual fund units and wants to make the switch. In this case, he would have to pay tax at 12.5% of ₹50 lakh-₹1.25 lakh, which is approx. ₹5.9 lakh. Such a tax burden might deter anyone from switching. However, calculations show that making the switch can still be profitable in the long run, even after paying tax for it (see below).

Compounding powers direct plans ahead

Usually, the gap between the expense ratios of regular and direct plans is around 0.5% to 1%. It may be even higher in the case of some funds. While this difference may seem small at the outset, it can significantly boost the direct plan returns over the long term due to the power of compounding.

Moreover, for long-term gains up to ₹1.25 lakh from equity mutual funds, there is no additional tax burden due to the switch, provided the investor doesn't have any other LTCG from equity.

Let's understand this with an example of a popular large-cap fund, whose annualised returns over the last 10 years are 13.79% for the direct plan and 13.07% for the regular plan.

• Total investment in 10 years: ₹5000 x 12 x 10 = ₹6 lakh

• Total corpus at 13.07%: ₹12,38,618

• Total LTCG: ₹12,38,618-₹6,00,000 = ₹6,38,618

• Total LTCG after tax exemption: ₹6,38,618-₹1,25,000 = ₹5,13,618

• Tax on ₹5,13,618 at 12.5% of gains: = ₹64,202

• Balance corpus after deducting tax: ₹12,38,618-64,202 = ₹11,74,416

What happens after the switch

Now let's see how returns may play out if the investor reinvests the balance corpus after deducting tax. For understanding, let's assume the following:

• Similar returns over the next 15-20 years in both direct and regular plans

• The amount is reinvested as a lump sum

Calculation shows that the gap between direct and regular corpus after 20 years could be around ₹18.5 lakh. Check the table below for other durations:

Please note that the above table is for illustrative purposes only. The returns shown are assumed. In real-life situations, returns may vary due to multiple reasons. Moreover, there is no guarantee that a scheme will replicate its past performance in the future.

However, the direct plan may still win over the regular plan over the very long term due to the difference in their expense ratios.

While the direct plan outperforms the regular plan over the long run, any decision to switch should be made after careful consideration. Regular plans are generally offered by distributors, who also provide significant handholding and guidance to investors.

Direct plans can be opted for directly by investors and may be suitable for those who do not require much handholding, or for those guided by advisors who recommend direct plans.