As a Certified Financial Planner, I often come across investors who hold on to underperforming mutual funds simply to avoid paying capital gains tax is a decision many investors end up regretting. Here’s an important principle to remember:-
“Don’t let the tax tail wag the investment dog.”
While taxes are an important consideration, they should not become a roadblock to making smart investment choices.
Why Do Investors Hesitate?
Many investors shy away from redeeming mutual funds even when the performance is subpar. Why? One common reason is the reluctance to pay capital gains tax. There’s a psychological barrier as well – “Why should I pay tax if I don’t absolutely need to redeem now?”
But in reality, this mindset can cost more than the tax itself.
When It Is Advisable to Exit a Mutual Fund?
- The fund is not meeting the performance expectation.
- It no longer aligns with your investment strategy or risk profile.
- There are better opportunities with other funds.
- You need funds for a planned financial goal.
Let’s take an example of Mr. Aniket, who was advised to redeem certain mutual funds because they were underperforming and didn’t align with the key investment parameters. But he hesitated – solely because of the capital gains tax involved. Years went by, the funds continued to drag down his overall portfolio returns, and he missed chance to compound his money in better-performing alternative.
Capital Gains Tax: It’s only on the gain
This is where many investors misunderstand the tax implications.
Capital gains tax is not charged on your full redemption amount – it is levied only on the gains, i.e., the profit you’ve made on your original investment.
So if you invested Rs. 100,000 and your investment grew to Rs. 150,000 your capital gain is Rs. 50,000. Considering 12.5% long-term capital gains (LTCG) tax, and exemption limit of Rs. 125,000 your tax liability would be just Rs. 3,125 – not on entire Rs. 150,000.
Understanding such nuances is an important part of effective tax planning.
A Simple Math behind It
Let’s take another example for understanding. Suppose you redeem a mutual fund and the capital gains amount to Rs. 100.
You’ll pay Rs. 12.5 as LTCG tax.
Now, you reinvest the remaining Rs. 87.5 in a better-performing fund.
If that new fund gives higher returns consistently, it can easily outpace the Rs. 12.5 you paid in tax – and deliver better long-term value.
So in essence, the tax you pay can be seen as a small price for better returns ahead.
This is where a well-structured investment planning approach, help make such decisions easier and well structured.
Thinking Long – Term, Not Just Tax – Saving
Tax-efficiency is important, but it shouldn’t override sound investment decisions.
Holding on to a poor investment just to save tax is like skipping a doctor’s visit to avoid the consultation fee – even if you are not feeling well.
You need to ask yourself:
- Is this fund helping me reach my financial goals?
- Does it still fit my risk profile?
- Could I do better elsewhere?
If the answer is no, then paying the capital gains tax and switching may be the smarter move.
Final Thoughts
Redemption decisions should be based on portfolio alignment, fund performance, and your financial goals – not just taxability. Sometimes, exiting an average fund, paying the tax, and entering a better opportunity can be the key to unlocking better long-term results.
Always evaluate the bigger picture—smart decisions today can significantly impact your financial future.