Understanding Long-Term and Short-Term Capital Gains When Selling Partial Units of Mutual Funds SIP

Introduction:

The tax treatment of selling partial units from a Systematic Investment Plan (SIP) of mutual funds is critical to understanding how your capital gains are classified as either long-term or short-term. The holding period of the units determines whether the gain is considered long-term or short-term, with significant implications for the tax you owe. This article delves into the nuances of this topic, ensuring you manage your SIP investments wisely.

What Are Long-Term and Short-Term Capital Gains?

Long-Term Capital Gains (LTCG): When you hold the units for more than 1 year before selling, the profit is classified as a long-term capital gain. Currently, in the context of equity-oriented mutual funds in India, there is a long-term capital gains tax of 12.5% with indexation benefits.

Short-Term Capital Gains (STCG): If the units are held for 1 year or less before selling, the profit falls under short-term capital gains. The current tax rate for STCG on equity-oriented mutual funds is 20%.

Practical Considerations for Selling Partial Units of Ongoing SIP

The tax treatment can be complicated, especially when dealing with partial units. Typically, the FIFO (First In First Out) Method is followed for mutual fund redemptions in India. This means that the oldest units are considered sold first, which can have a direct impact on the classification of your gains.

FIFO Methodology and Its Impact

Under the FIFO method, your oldest units are treated as sold first. If you hold your units for more than 1 year, the sale of those units is considered a long-term capital gain. Conversely, if the units were held for a year or less, the sale is treated as a short-term capital gain.

This can be a significant factor in your tax liability. For example, if you hold units for more than a year but sell some in a given quarter, those units are considered for long-term gains. If you sell units that were held for less than a year, those gains are treated as short-term, resulting in a higher tax rate.

Specifying Lots When Conducting Sales

When you sell partial units of your mutual fund SIP, you can specify the lots (units) you wish to sell. This allows you to manage the capital gains between short-term and long-term shares. By carefully planning the lots, you can minimize your tax liability.

For instance, you can choose to sell the oldest units first to avoid short-term gains. Alternatively, you can opt for the LIFO (Last In First Out) Method to maximize the benefit of long-term capital gains. However, choosing LIFO may not be advisable due to potential IRS issues. A safer approach is to set your brokerage platform to use LIFO as your default method.

Default and Your Brokerage Platform

Most brokerage platforms default to the FIFO method, as this benefits the IRS by yielding more tax revenue. It's important to note that the tax code can change, particularly with the current political climate and potential legislative changes.

The IRS prefers the FIFO method because it results in higher tax revenue. With Congress in session, changes to the tax code are always a possibility, making it necessary to stay updated on your tax software and practices.

By setting your brokerage platform to default to LIFO, you can ensure that the oldest units are sold first, which can be beneficial for minimizing tax liability.

Conclusion

Understanding how the FIFO and LIFO methods apply to the selling of partial units of your ongoing mutual fund SIP is crucial for tax planning. By careful consideration of your sales and the method you use, you can optimize your capital gains and minimize your tax liability. Always stay informed about the latest tax laws to ensure you make the best financial decisions for your investments.