Switching from regular to direct mutual funds: Know the hidden tax cost — and when the move actually pays off

Both direct and regular plans of a mutual fund have the same portfolio and are managed by the same fund manager. The key difference is the expense ratio.

Regular plans have higher expenses, which reduce their NAV compared with direct plans. Over time, the lower expense ratio of direct plans can translate into higher returns as the investment compounds.

This often prompts investors to switch from regular to direct plans. But there are hidden tax implications and other factors you must consider.

What is the tax cost of switching from regular to direct plans?

Says Mukesh Kumawat, Executive Director, Anand Rathi Wealth, “Switching from a regular plan to a direct plan of the same mutual fund is treated as redemption of the existing units and a fresh investment in the new plan.”

The same treatment applies when switching from direct to regular plans.

He added that direct and regular plans have different ISINs and are therefore treated as separate investments for tax purposes. The same applies to switches between Growth and IDCW options, as each has a separate ISIN.

“Any capital gains arising on the redemption are taxable in the year of the switch,” Kumawat stated. The tax treatment remains the same whether the switch is made through an investment platform, broker or directly through the AMC.

When can switching have zero tax liability?

Kumawat noted that there are mainly two circumstances:

• If the fund has delivered zero or negative returns at the time of switching, there is no capital gain and therefore no tax.
• If equity fund units have been held for more than 12 months and total long-term capital gains from all equity investments during the financial year are within the ₹1.25 lakh exemption, there is no tax liability.

How to consider the tax impact when switching from regular to direct plans?

Suppose an investor has a lump-sum investment of ₹1 lakh in the regular plan of a large-cap fund. The regular plan has an expense ratio of 1%, compared with 0.5% for the corresponding direct plan.

The investor has remained invested for two years, during which the fund has generated an average annual return of 10% before expenses.

Kumawat explained this as follows:

• Assuming a 10% pre-expense return, the regular plan would earn about 9% and the direct plan 9.5%.
• After two years, ₹1 lakh would grow to roughly ₹1.19 lakh, creating an LTCG of about ₹18,800.
• Gains on units held for more than 12 months are treated as long-term and taxed at 12.5%.
• If the ₹1.25 lakh annual LTCG exemption has already been exhausted, the tax on the ₹18,800 gain would be around ₹2,350, reducing the amount available for switching to about ₹1,16,450.
• The direct plan would take roughly 4 to 5 years after the switch to make up for the initial tax outgo and catch up with the regular plan.

How can investors decide whether to switch from regular to direct plans?

Kumawat noted that “there are multiple factors to consider, so the decision should not be based only on the expense ratio”.

• Check the fund's year-on-year performance and alpha consistency.
• Assess whether the chosen distributor of the regular plan adds value through fund selection, portfolio reviews, and investment discipline.
• Calculate the capital gain, applicable tax, and whether the ₹1.25 lakh LTCG exemption is already used elsewhere.
• Compare the post-tax amount moving to the direct plan with annual savings from the lower expense ratio.
• If the remaining horizon exceeds the breakeven period, switching may be financially beneficial. Otherwise, it may not make sense.
• Consider the FIFO rule for SIP investments and any applicable exit load before switching.