Mutual Fund Switch vs. Redeem: A Calculator and Guide to Smarter Decisions

Mutual Fund Switch vs. Redeem Calculator

Introduction

Recently I got a query from a person related to mutual fund switching. He was confused whether to use the switch option or to redeem the units all together.

It is common to face this kind of dilemma.

When our financial needs change, especially when substantial long-term investments are involved.

In this case the person was considering what to do with his Rs30 lakh investment in a pure equity mutual fund. He has been holding on to it for over 3.5 years.

Now, due to some urgency, he wants to sell his mutual fund units for cash (planning to keep in savings account). He was also aware that Long-Term Capital Gains (LTCG) tax will apply upon redemption.

Someone has also suggested him that, instead of redeeming, switch to an Overnight Fund.

From the Overnight Fund, the person was expecting about 5% return compared to a 3.5% savings account interest.

How this person should go about managing his mutual fund holding? Will it be better for him to redeem or switch to an Overnight Fund?

So let's start with the basics first and then we'll go into the specific answer.

What Does a Mutual Fund Switch Mean?

A mutual fund switch is the process of transferring your investments from one mutual fund scheme to another.

This can occur within the same fund house or involve moving to a different fund house.

Generally, investors opt for a switch to align their investment strategy with evolving financial goals.

They may also do so when the market conditions change. For example, there are investors who will prefer switching from a pure equit fund to a gold fund in case of an all out war (like WWIII). Generally, during a war scenario markets go into a deep and prolonged bear phase.

When people age, their risk tolerance also change. In such case, people may prefer switching from all equity funds to a balanced fund.

The Crucial Point - Is Switching a Redemption Event?

It is important to understand that when you switch from one mutual fund to another, it is treated as a sell transaction in the original scheme and a fresh purchase in the new one.

This means any gains from your original investment become subject to capital gains tax.

In case of our example, holding the equity fund for over 3.5 years means Long-Term Capital Gains (LTCG) tax will apply.

For equity funds, LTCG is taxed at 10% on gains exceeding Rs.1 lakh in a financial year.

This tax liability arises the moment you "switch out" of the equity fund, as it is considered a redemption.

The Role of an Overnight Fund

An Overnight Fund is a type of debt mutual fund.

These funds primarily invest in debt and money market instruments with a very short maturity period, often just one day.

These instruments are known for their high liquidity and aim to provide returns slightly higher than a savings bank account, with minimal risk.

When you switch your post-tax corpus from the equity fund into an Overnight Fund, any further gains from the Overnight Fund will be taxed based on debt fund rules.

For debt funds held for less than three years, Short-Term Capital Gains (STCG) are taxed as per your income tax slab.

For debt funds held over three years, LTCG is taxed at 20% with indexation benefit.

Given the very short-term nature of Overnight Funds, any gains accrued would likely be short-term and minimal.

Is This the Right Approach for You?

The concern of the person in our example about maximizing returns is valid.

Parking funds in an Overnight Fund, which typically yields around 5% annually, is indeed better than a savings account's 3.5% [Query].

This strategy is beneficial for the period the money is held in the Overnight Fund after the initial tax event from your equity fund.

However, it is crucial to clarify that switching to an Overnight Fund does not allow you to avoid the LTCG tax from your equity fund.

The tax on your equity gains is triggered as soon as you exit that fund. Whether the exit is done via a direct redemption or a switch.

In case a person has decided to switch, here is a key benefit:

The primary advantage of switching directly to an Overnight Fund, rather than first redeeming to your bank account and then re-investing, is the seamless transfer of funds. This avoids the time lag and potential manual steps of waiting for redemption proceeds to credit your bank account before making a new investment.

Key Considerations Before Any Switch

Before making any mutual fund switch, whether to an Overnight Fund or any other scheme, consider these important factors:

• Tax Implications: Always confirm the tax consequences for both the fund you are exiting and the fund you are entering.
• Exit Loads: Check if any exit loads apply to your current fund if you switch before a specified holding period. For funds held for 3.5 years, it is less common for equity funds to have an exit load, but verifying is essential.
• Purpose of the Switch: Ensure the new fund aligns with your revised financial goals and risk tolerance. In our example, an Overnight Fund is suitable for temporary parking of funds.
• Investment Horizon: If you need the funds immediately, an Overnight Fund offers high liquidity.
• Performance and Costs of New Fund: Though Overnight Funds are relatively stable, always review the expense ratio and past performance for any new fund you consider. In our example, the expense ratio of Overnight funds are generaly low ay 0.15% or lower.

Conclusion

The idea of switching to an Overnight Fund to earn a higher return than a savings account is a sound strategy for parking funds temporarily after exiting equity investment.

However, it is important to remember that the capital gains tax on equity fund will still be levied.

As the switch itself is treated as a sale, for tax purposes, the gains will be taxable.

But this is also true that Overnight Fund provides a marginally better yield while the money awaits its next use.

Have a happy investing.