How switching MFs to dividend option to book unrealised loss can reduce your tax bill

First, let us understand the tax rules for selling short term and long term investments. Short-term capital gains (STCG) on assets held for less than a year are taxed at 20% and long-term capital gains (LTCG) on assets held for over a year are taxed at 12.5% beyond ₹1.25 lakh. By selling loss-making investments before 31 March, investors can offset the losses against STCG or LTCG from other investments, thereby reducing the taxable amount.

Switching strategies

But what if you are bullish on the mutual fund that is performing poorly and do not want to stop investing in it? You can still book the loss and immediately repurchase the MF. Financial advisers and wealth managers often switch from the growth option of the MF to the income distribution cum withdrawal (IDCW) plan option, and then switch back to the growth option once the losses are booked. IDCW are the dividend plans of the MF schemes.

“Switching from growth to dividend option of an MF is treated as redemption. So, you are booking losses while not actually selling the holding. The switch happens within the same day. The very next day, we place the switch-out request to move back to the growth option,” said Bikam Chand, a family office wealth manager.

There is no volatility risk in this strategy as the switch happens on the same day as the net asset value (NAV) of both schemes. “The number of units after completing this whole exercise remains the same except for a marginal decrease as stamp duty and STT (securities transaction tax) is applied. There is no change in the number of units on account of market movement,” Chand added.

Investors should note that depending on the fund’s policy, there might be exit load implications. Also, when you switch back to the growth option at the end of the exercise, the exit load timeline will be reset.

Also, if an AMC declares a dividend on the day you switch, there will be a tax liability on you. “This can be avoided by checking with the AMC the tentative dividend declaration date,” said Chand.

The only limitation in this strategy is that not every MF scheme gives a dividend option. The alternative is to book the loss and buy the same scheme through a family member with a different PAN. “Say, two adult siblings invest in scheme A and B. Both of them redeem ₹5 lakh worth of units from their respective schemes and reinvest in the other one,” said Dhruv Goel, an investment practitioner.

“Of course, the prerequisite is that the investment planning in such families is done collectively and not individually so that there are no conflicts in the future,” Goel added.

This is a commonly practised strategy among HNIs. When one individual sells their MF or stock holdings, the same amount is reinvested on the same day on another family member’s PAN. It is easier for HNIs to execute this without liquidating more than one scheme as they have liquid cash to deploy, which may not be possible for small retail investors.

Goel says small investors should conduct tax loss harvesting only if they have huge losses. “If you are saving ₹5,000- ₹7,000 in tax by doing this, it’s better to keep holding the investments,” he said.

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Sell only if you can hold for a year

Only those investors should conduct growth-dividend-growth switch for loss offsetting who can hold their MF for at least a year after conducting this exercise. Selling the MF units within one year will make it a short-term investment, resulting in 20% STCG tax.

“If the loss you have booked turns into profit and you sell it within one year, you may pay more tax on the gains than what you may have saved,” said Chand.

To explain this with an example, say Mr A purchases stock for ₹100. After nine months, markets corrected and the stock fell to ₹80. He booked losses and set it off against LTCG, thereby saving tax of ₹2.5 (12.5% of ₹20). Now, four months later, the stock recovered and he sold it at ₹130. In this case, he will end up paying STCG of ₹10 (20% tax on ₹50). Effectively, he paid ₹7.5 in taxes ( ₹10 minus ₹2.5 ).

Had Mr A not done tax harvesting, he would have paid only ₹3.75 as LTCG tax (12.5% on ₹30).

Tax loss harvesting is a timely exercise of selling stocks or MFs in loss to offset it against capital gains from other profitable investments to reduce taxes.

If you intend to sell an MF holding in the coming financial year before February 2026, it is better to not book losses on them now as you will be able to set off the booked losses next year itself.

In fact, investors should conduct tax loss harvesting with any strategy they are adopting only if they can hold the MFs or stocks for at least one more year after booking the losses, say experts.

“It is prudent to conduct tax loss harvesting only for those stocks or MFs for which you are bullish for the next three to four years,” said Goel.

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Tax saving or deferment

An efficient tax loss harvesting exercise also depends on whether you are offsetting STCL (short-term capital loss) or LTCL (long-term capital loss). LTCL can only be set-off against LTCG, whereas STCL can be set-off against both LTCG and STCG.

“That’s another reason one needs to hold the MF/stock where they have booked loss for more than one year after this exercise. This ensures that they will have LTCG (assuming market recovers) which will get taxed at a lower rate in future. So they saved by lowering STCG in the current year and then paying lower LTCG tax in future,” said Chand.

While setting off STCL can actually save tax as the future tax liability is at a lower rate of 12.5%, in the case of LTCL, the taxpayer essentially defers the tax liability.

However, by postponing the payment, you allow your capital to compound over time, says Arihant Bardia, CIO and founder, Valtrust. “You are essentially borrowing from your future self, but with the advantage of earning returns in the interim. Done prudently, this strategy can significantly enhance long-term portfolio growth.”

Chand says in the case of LTCL, selling the investment should be evaluated as an investment decision rather than a tax planning strategy.

“The usual tendency of investors where they have seen loss in a stock/MF held for a long tenure is to sell it at the very moment it turns into profit. This is a bias which is difficult to overcome. Hence there is a possibility of not holding it for more than one year after tax harvesting.”

In that case, one may end up paying higher taxes at a short-term rate. “Hence, in the case of LTCL it’s better to evaluate whether to hold it or not. In case one decides not to hold it, one can book losses and move on (don’t buy back). The risk of paying higher STCG tax is eliminated thereby.”

Currently, most investors with losses are expected to deal with STCL as the investments done in the last one year were during market peaks and those would have recorded losses with the downturn. “It’s unlikely any investors who invested in the last four to five years would have LTCL. So, March 2025 is a good opportunity to book those unrealised STCL to save tax,” said Goel.

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