The answer is an unequivocal yes. You might have to do a bit of running around initially but the excess returns will more than compensate for it. Go through this post to know more about direct plans of mutual fund schemes and how direct plans offer better returns than regular plans. For equity funds, the excess return of direct plans ranges from 0.25% to 1% per annum. This can cause a huge difference in the long term. The excess return is lower for debt funds.
I have received a lot of queries from a number of investors asking whether they should switch their investments from regular plans to direct plans. The answer is Yes. However, there are certain costs attached with switching of units from regular plans to direct plans. Such costs must be considered before making the decision. There is another common confusion about how direct plans offer better returns despite having a higher NAV than regular plans. Read this post to find out how this happens.
Switch from regular to direct plan is considered as redemption from regular plan and a fresh investment into the direct plan of the mutual fund scheme. This gives rise to certain costs. Let’s see how these costs can affect your decision to switch to direct plans.
Costs associated with redemption of mutual funds
- Exit load: For equity funds, there is a penalty that the fund house imposes for withdrawing from the fund too early. Typically, the fund houses charge up to 1% of the redemption amount if you redeem within 1 year.
The extent of load and duration (up to which exit load is charged) varies across funds. A few funds charge exit load if you exit within 3 years. So, you are advised to check such conditions for your fund before you make the switch.
- Capital Gains Tax: If you redeem equity mutual fund units within 1 year (3 year for debt funds), the resulting gains are treated as short term capital gains. If you redeem equity fund units after 1 year (3 years for debt funds), the resulting gains shall be considered long term gains.
For equity funds, short term capital gains are taxed at 15% while long term capital gains are exempt from tax. For debt funds, short term gains are taxed at your marginal income tax rate (income tax slab) while long term gains are taxed at 20% less indexation. For more on taxation of mutual fund units, please go through following post.
Apart from these costs, Securities Transaction Tax (STT) is also charged on sale of equity fund (and not on debt funds). However, the impact is much lower as compared to exit load and capital gains tax.
Additional Point to note
Each installment of a Systematic Investment Plan is considered a fresh investment for the purpose of exit load and capital gains. Let’s assume the exit load in your fund is charged at 1% for redemption within one year.
Let’s assume you have started a SIP in the equity fund on October 15, 2015. You make monthly investments on 15th of each month. Units purchased through installment on October 15, 2015 can be sold on or after October 16, 2016 to avoid exit load and capital gains tax. Units purchased through installment on November 15, 2015 can be redeemed on or after November 16, 2016 to avoid any exit load and capital gains tax.
You can see every installment (through SIP or otherwise) is considered a fresh investment. You must keep this in mind.
Additionally, you can not switch units in ELSS (equity linked savings schemes or tax saving mutual funds) before completing 3 years. The reason is switch is considered sale of regular plan units and purchase of direct plan units. Since you cannot sell ELSS units before 3 years, you cannot switch before 3 years.
If you are in the negative (loss) on your MF investments, there will no capital gains tax implication. However, exit load implications will still be there if you redeem within specified period.
What should you do?
- Stop SIP in the regular plan of the MF scheme. Start SIP in the direct plan.
- For the regular plan units that have already completed their exit load period (and do not have adverse capital gains tax implications), you can switch those units to direct plan.
- For the remaining regular plan units, you can wait till the exit load period gets over. Subsequently, you can switch to direct plans.
Image Credit: Simon Cunningham, 2009. You can download the original image and information about usage rights from Flickr/Lendingmemo