Switching in Mutual Funds: Meaning and Taxability

A mutual fund is a managed portfolio of investments that investors can purchase shares of, Mutual fund managers pool money from many investors and invest the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio.

A new concept of switching in mutual funds came in front of me when my client questioned me about its taxability, Hence I decided to let my readers know its concept and taxability in this article based on my research, we will discuss the same in detail

Do you invest in mutual funds? What if it underperforms?

When investing in mutual funds, it’s common to encounter scenarios where a fund may underperform or you may find a more suitable scheme. In such instances, you have the option to switch your investment between schemes, known as switching. However, navigating this process involves adhering to specific steps and regulations, and it’s important to understand that your decision to switch can have implications and outcomes.

What is switching in mutual funds?

Switch is a term used to denote the process of moving one’s investment (in whole or in part) from one scheme to another within the same fund house. Additionally, you have an option of making a switch-in or switch-out between funds of different fund houses. In case of a switch-in, you make a redemption in one fund and invest it in another while in case of a switch-out you transfer your investments from one fund house to another. It should be noted that there may be exit loads and taxes on capital gains involved in these transactions

One can choose to convert his regular plan into a direct plan under the same fund. Regular plans involve distributor commissions, unlike direct plans which do not thus reducing overall costs when investing in the scheme. Nevertheless, with a direct plan, you will need to handle your investment management individually.

What are the advantages of switching?

A single advantage that comes along with switching is the possibility of stopping investment in an underperforming fund and starting in a good one, which will significantly increase your portfolio return. Also, by switching to a direct plan from a regular plan, you can decrease your investment cost. On another note, switching is an effective tool when planning goals. It can help you maintain your wealth by turning from equity to debt as you draw nearer to achieving your goal.

Several reasons can lead to switching between mutual funds. For instance, you may want to shift your investment strategy and move from regular to direct; alternatively, if you are nearing your goal and would like to protect your capital, you might want to switch from equity to debt funds. Another reason could be due to the underperformance of the fund in which you have invested and consequently wish to invest in a better-performing fund. You might also consider moving between growth and dividend or vice versa.

Whatever the reason, you must follow the same process for switching your mutual fund investments.

How to switch from one mutual fund scheme to another?

You can change from one scheme to another within the same fund house by filling out a switch form from the asset management company (AMC) or visiting their website and then switching your investments. An alternative route would be to go to the websites of mutual funds’ independent platforms and make this switch easily.

The investors need to understand that if their investments do not exceed Rs 2 lakhs, then the transaction will happen on the same day if they have requested it before 3 pm. But if the amount invested crosses the Rs 2 lakh mark, you may have to wait for two days or so to get your mutual fund units.

To change the funds between two different fund houses, you will need to redeem your investments in the old fund and then repurchase the new units. You should wait until you get your money back from the old fund before you can invest in the new one.

What are the factors to consider before switching?

Switching your mutual fund investment has some consequences. The factor you must consider before switching is Exit load which means mutual funds have an exit load, which is a penalty for withdrawing your funds before a specific duration, which is one year for most mutual funds. If you switch your investments within one year, you will have to pay an exit load of around 1% to the fund house, secondly a lock-in period, Equity Linked Saving Schemes (ELSS) come with a lock-in period of three years. This means you cannot withdraw your investments before three years. So, you cannot switch your investments before the completion of three years. However, you can stop investing in the fund, another factor is Taxation, Switching involves selling your investment in one fund (or plan) and buying units of another fund (or plan). If you have made a profit on your investment, it will be taxable at the applicable rate, last one is portfolio management, Switching from a regular to a direct plan requires you to manage your portfolio. You will have to track and monitor your portfolio on your own. Switching to a direct plan also requires you to have market knowledge that will help manage your portfolio.

What are the Tax implications of switching between mutual funds?

When you switch out and switch between mutual funds, your gains will be taxable. If you switch out of an equity fund, your gains will be taxable similar to equities. Short-term capital gains tax will be levied for gains if you switch within one year. In contrast, long-term capital gains tax will be levied for gains above Rs 1 lakh if you switch after one year from the investment date.

If you are switching from a debt fund, gains within three years are considered short-term capital gains and will be taxed per your income tax slab. The long-term capital gains tax is gains earned after three years from the date of investment and will be taxed at 20% with an indexation benefit.

In the case of hybrid funds, they are taxed as per their allocation to equity and debt. If the portfolio has more debt, they are taxed like debt funds. In contrast, if the portfolio has more equity, they are taxed like equity funds.

Is there a penalty for switching mutual funds?

No, as of today there is no penalty for switching between funds. However, fund houses can levy an exit load if you switch before a specific period but the gains you have earned so far are subject to capital gains tax which depends on the duration of fundholding

To sum up, mutual fund switches could be a potential way for the investor to gain control over their investment strategy on a more comprehensive scale, considering significant factors such as performance rates of the fund, investment goals, and expenses. When an investor considers switching from one fund to another, whether within the same house or to a different one, they must understand the tax implications and consequences of this decision. Swaps can enhance returns and lower costs, but it is necessary to be aware of exit loads, lock-in periods, taxation implications, and how they will affect portfolio management. Thus, an investor who weighs these factors against his or her financial objectives will be able to manage mutual fund investments effectively.