Beware of LTCG tax while recycling your ELSS mutual funds

The Union Budget 2018-19 reintroduced the Long-Term Capital Gains (LTCG) tax on equity funds, much to the disappointment of individuals who are heavily invested in Equity-Linked Savings Scheme or ELSS. Most of these investors recycle their investments in these tax-saving mutual funds. The strategy is quite simple – recycle your old mutual fund investment and claim another deduction on it after the 3-year lock-in period. However, the reintroduction of the LTCG tax might impair the pitch for these investors.

According to the Union Budget 2019, the finance minister proposed to tax long-term capital gains on equity mutual fundsabove Rs1 lakh at 10% without the benefit of indexation. Under Section 80C of the Income Tax Act, 1961, investments in ELSS funds qualify for tax deductions for investments up to Rs1.5 lakh. However, some individuals, instead of making new investments, tend to pull-out their existing investment after the mandatory lock-in period of 3 years and re-invest in ELSS again to claim tax deductions.

This practice, which is often frowned upon by mutual fund experts, is known as recycling of mutual funds. After the reintroduction of the LTCG tax, individuals indulging in this practice would be liable to pay a tax of 10% on their long-term capital gains. However, if the returns on your ELSS investments are less than Rs1 lakh, you are not liable for the same.

Hence, most investors would be able to avoid the new tax upon recycling their ELSS mutual fund investments because not many would actually make long-term capital gains beyond Rs1 lakh in a short span of 3 years. For instance, if you invest Rs1.5 lakh in ELSS investments, your investment would have to clock an annual growth rate of 18.36% to be able to make gains over Rs1 lakh.

Mutual fund experts believe that individuals who wish to recycle their ELSS investments would continue to do so despite the new LTCG tax. For instance, if an individual fallsin the 20% tax bracket, it makes sense to pull out Rs2.5 lakh from the investment, pay Rs5,000 as tax, and re-invest Rs1.5 lakh to be eligible for tax exemption. However, one should be aware that pulling money early could result in losing the advantage of the power of compounding over the years.

Additionally, experts believe that recycling investments won’t be a bad idea in all cases. Investors who do not have extra surplus cash to invest can opt for recycling their investments. Though most mutual fund advisors usually shun this method, one can use it as their last resort.

Whether you decide to recycle your investments or have madeup your mind for fresh new investments, you should always consult your mutual fund advisor. Additionally, your mutual fund investment should always be in alignment with your financial objectives/goals, investment horizon, and your risk appetite. Mutual fund investments do not follow the concept of ‘one shoe fits all’; hence, mark your financial priorities and invest in mutual funds accordingly.