Switching from Regular to Direct Funds - Tax Implications and Breakeven Point

Switching from 'Regular' to 'Direct' Mutual Funds can be painful in terms of paying taxes.

Let's see how long it takes to break even the taxes when we make the bold move from regular to direct mutual funds.

Background

Investing in Regular mutual funds is like taking a wrong path towards a destination. The longer you keep walking, the more painful it is to come back to the right path of direct mutual funds. As you regular fund portfolio grows, you fear paying high capital gain taxes if you have to liquidate the regular funds and move to direct funds. But if you keep walking the path of regular funds, you keep accumulating lesser returns every year.

So, let us calculate how long does it take to break even the taxes when we make the bold move from regular to direct mutual funds.

Most of the freedom seekers we coach in the ELITE Program already hold multiple mutual funds in their portfolio before they come to us. 

Challenges in the existing Mutual Fund Portfolio

1. MFs were subscribed without creating any investing strategy. So, the allocation to risk-based investing is usually horribly wrong.

2. Mutual Fund portfolio is overdiversified. There are just too many funds of the same type. e.g. 5 ELSS funds, 3 Small Cap Funds etc.

3. There are too many funds of all types. A typical portfolio has funds which are thematic (banking, technology, health, value, contra etc.), hybrid funds, large-cap funds, mid-cap funds, small-cap funds, flexi-cap funds, international funds etc.

4. Most funds are regular funds.

It is usually easy to guide investors on the first three points once we have created an investing strategy for them.
But the biggest hurdle is in convincing the investors to move from regular to direct funds.

Moving from Regular to Direct Funds: A 3-step process

There is no quick way to move from regular to direct funds. Essentially, they are two different funds even if the fund name and the fund house are the same. The movement involves three basic steps:

1. Liquidate your regular fund.

2. Wait for the money will come to your linked savings account after 1-2 days.

3. Do a lumpsum investment in the direct fund.

Tips before you move from Regular to Direct Mutual Funds

The care that you need to take when you move from a regular to direct fund:

1. Movement has to be lumpsum (in one shot) (No SIPs)

2. Movement should be done asap (preferably 1-2 days) so as to reduce the risk of market volatility during the movement period. 

[For same day movement strategy: Read FOOPS!]

What holds the investors from this movement

1. Lethargy - It seems too much of work to liquidate and reinvest. This may also involve stopping existing SIPs on the regular fund and starting new SIPs on the Direct Fund. Most people want to stay in the comfort zone.

2. Tax Implications - Liquidating a regular fund would lead to tax implications, and most investors are skeptical of paying taxes.

Should you liquidate and pay taxes?

The short answer is YES. 

Even after paying all taxes, and moving the regular funds to direct, you will breakeven and move ahead of the regular fund corpus in 3-4 years. 

If you stay invest any longer than this, direct funds corpus will accelerate far ahead of regular funds. So, if you have an investment horizon of 3-4 years, it makes all the financial sense to move from regular to direct funds even after paying capital gains tax.

Even if you plan to stay invested for lesser than 3-year tenure, remember that you still need to pay taxes on liquidation of regular funds. So, there is no escaping taxes anyway.

How to calculate the precise breakeven period for your fund

We worked out an excel sheet which takes your inputs (amount, returns, brokerage, tenure etc.) and helps you calculate the exact tenure you need to stay invested to exceed the returns from regular funds even after paying all taxes. 

This excel uses some standard data, which you can rectify based on your mutual fund

CLICK HERE use the online excel here and give it a shot

Summary

Don't be lethargic in moving from regular to direct funds. It can significantly impact your final corpus over time. If you have 3–4-year investment tenure, just go ahead with the movement in one shot even if you have to pay taxes.

Regards

Manoj Arora
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