Retirement is typically perceived as the onset of a financially independent life; however, this phase requires a completely different investment and tax strategy. In case the major part of your retirement portfolio is invested in mutual funds, the sale of units or withdrawal through a Systematic Withdrawal Plan (SWP) will generate taxable capital gains. Nevertheless, with careful planning, retirees can potentially reduce the level of their total taxes payable without affecting their financial independence.

 The retirement does not entitle you to a concessional capital gains rate simply because of your retirement status. However, since there will be certain changes in the structure of your income post-retirement, you can exploit certain tax planning strategies which will allow you to save on mutual fund capital gains tax in an effective manner.

Thus, there are several methods of minimising tax payable on mutual fund capital gains after retirement that are legal. Among those methods are the distribution of withdrawals between financial years, the optimisation of applicable capital-gains exemptions, selection of Growth over IDCW whenever possible and planning of SWP withdrawals. It is worth mentioning that pension, interest payments, rentals and other forms of income should be taken into account before redemption.

In this article, we will discuss the various ways to pay lower income tax on mutual fund capital gains post-retirement.

Why Mutual Fund Capital Gains Matter So Much in Retirement

As soon as you retire your salary stream stops coming in, your investments form the backbone of your income sources. Mutual fund capital gains, therefore, come into the picture whenever you cash out your shares, whether equity, debt, or hybrid funds. Failing to take note of the implications is an amateur error, especially since many retirees are guilty of it until they realize it at tax filing time.

Understanding the implications of capital gains for your mutual funds is not an option; it is mandatory if you wish to sustain yourself into your later years.

Short-Term vs Long-Term Capital Gains

Before proceeding further with tax saving tips, we should first briefly learn about the basics of taxation of mutual fund capital gains, as this is the basis of all our future discussion. 

Short-Term Capital Gain (STCG)

Short-Term Capital Gains (STCG) are made when you sell your mutual fund units during the applicable short-term holding period. Units in the case of equity-oriented mutual funds that are held for up to 12 months are generally considered to be STCG. The tax rate applicable for eligible equity-fund STCG currently stands at 20% (subject to relevant provisions).

Suppose you invest ₹5 lakh in an equity mutual fund, and sell your units after eight months at ₹5.80 lakh. Your capital gain will be ₹80,000. If the capital gain is considered to be STCG from equity-fund, then the special tax rate will apply to that capital gain.

In case of debt-oriented mutual funds, some additional considerations are required. The tax rate depends on various factors including investment profile, acquisition date, and tax provisions applicable at the time of acquisition. Some mutual funds having high debt component, which were acquired on or after 1 April 2023, may attract tax on their gains as STCG at income-tax slab rate.

Long-Term Capital Gains (LTCG)

Long Term Capital Gains (LTCG) are typically applicable for mutual fund units of an equity nature that have been held for more than one year prior to being redeemed. The tax structure is typically more favorable in comparison to STCG.

At present, LTCG that qualifies under equity mutual funds is taxable at 12.5% above the threshold of ₹1.25 lakh, annually, applicable exemptions based on the relevant conditions.

This difference can turn out to be especially significant for those people who are nearing the age of retirement or are already using their investments as a means of getting income. Proper planning related to timing and the amounts of your redemptions can help you maximize the annual exemptions for LTCG and save on taxes.

Remember that all mutual funds do not necessarily follow the same tax structure. The equity funds, debt oriented funds and some others are subject to separate taxation rules. So, make sure that you know the specific category your fund belongs to before you make any decision on redemption.

How to Pay Lower Tax on Mutual Fund Capital Gains After Retirement?

Maximize Use of 1.25 Lakh Exemption Limit

As per current tax regulations in India, Long-Term Capital Gains (LTCG) on equity-oriented mutual funds are entitled to get exempted from taxes up to ₹1.25 lakh per annum. Any LTCG beyond ₹1.25 lakh will be taxable at the rate of 12.5%.

This tax exemption provision can be particularly helpful for retirees and other investors having a substantial investment portfolio in mutual funds. Rather than selling a large number of units when you require a significant sum of money, you should think of taking advantage of this tax exemption scheme annually by selling sufficient number of equity units to earn a tax-free return up to ₹1.25 lakh even if you do not require any cash.

It is essential to note that there is no intention to withdraw money from your account. You may reinvest the money earned through selling of units into the same mutual fund or another equity-oriented mutual fund depending upon your financial planning.

Spread Out Your Redemptions Strategically

As opposed to liquidating a big chunk of your mutual fund investment at once, opting to withdraw lesser amounts over time will prevent the conversion of your mutual fund capital gains into higher bracket taxable income.

• Redeem only what is needed for the purpose of expenses each year – In case your pension, interests or any other income suffices to meet your expense needs, there is probably no need to liquidate a big part of your mutual fund investment.
• Delay withdrawing in bulk unless there is a compelling reason to do so – This will cause a big taxable capital gain in one and the same financial year. Opting to withdraw over time should be considered if this is possible in your case.
• Take note of your LTCG exemption limit each year – With respect to eligible equity-oriented mutual funds, pay attention to your annual LTCG exemption and capital gains already realized in the year.

In essence, the main thing is not to be motivated by the amount of money present in your mutual fund portfolio when withdrawing from it.

Harvest Capital Losses

Before the end of the financial year on 31st March, go through your mutual fund portfolio and find out which funds are underperforming or do not suit your financial objectives. The sale of your eligible investment in loss will allow you to offset capital gains and reduce your tax burden through a process called tax loss harvesting.

Long Term Capital Loss (LTCL): A LTCL can be generally offset against Long Term Capital Gains (LTCG) only.

Short Term Capital Loss (STCL): A STCL can generally be offset against both Short Term Capital Gains (STCG) and Long Term Capital Gains (LTCG).

Carry forward losses: If your eligible capital losses cannot be completely adjusted against the gains in the same year, then such capital losses can be generally carried forward for a period of 8 assessment years only provided that income-tax return is filed within the prescribed due date.

Remember not to sell any fundamentally good mutual fund just because you want to book losses for tax saving purpose.

Choose Debt Funds and SWPs Thoughtfully

Instead of withdrawing sporadic lump sums from the fund, consider creating a SWP for your regular expenses. SWP is simply withdrawing a certain sum at a regular interval from your mutual fund investment. The idea behind using the SWP strategy is that it helps you withdraw a certain sum of money after retirement, just like receiving a salary on a monthly basis.

The good thing about using the SWP strategy is that only the gain component is subject to taxes; the full withdrawal amount does not get taxed. This is in contrast to the fixed deposit, where the entire interest amount is taxable.

Switch from IDCW to Growth Option

In case you hold any mutual fund under the IDCW (Income Distribution cum Capital Withdrawal) plan, it might be worthwhile considering whether you should change over to the Growth plan as per your retirement plan and tax planning considerations.

Under the IDCW plan, every time there is a distribution made by the mutual fund scheme, the income received by you is generally taxable in your hands as per the applicable income tax slab rate. It does not offer the same kind of fixed tax rate which is applied to long term capital gains from eligible equity oriented investments.

This becomes especially relevant post-retirement or for those falling in the 20% or 30% tax brackets, as IDCW income will increase your tax liability even if you do not require the income immediately.

As against this, the Growth plan does not distribute any periodic income to you; rather the income stays reinvested within the mutual fund and is shown through the increase in unit values.

Consider Asset Rebalancing

As you near retirement, reducing your portfolio’s volatility takes priority, but relying only on debt investments may not be the best way from a taxation perspective. You should rather see if Equity Savings Funds or Multi-Asset Allocation Funds can offer a balance of stability, diversification, and tax efficiency.

Pure debt mutual funds may be more expensive from a tax point of view as they are taxable as per your applicable income-tax slab rates and do not get indexation benefit anymore. Higher tax bracket taxpayers will face losses in net gains from their investments.

Equity Savings Funds are an investment mix of equity, arbitrage and debt, while Multi-Asset Allocation Funds have equity, debt, and commodities among others. Investments that comply with the required conditions to be classified as equity can get tax benefits of equity orientation. Equity-oriented funds which are eligible can have their Long Term Capital Gains charged at 12.5% over the exemption limit of ₹1.25 lakh.

Consult a Tax Professional Before Big Decisions

Listen, we understand that no one likes to pay for any kind of advice, especially when information is available everywhere for free on the internet. But the reality of the matter is that tax laws pertaining to mutual fund capital gains are complicated, and they are revised rather frequently. The assistance of a chartered accountant can provide you with redemption solutions that will work well in your particular situation.

 Conclusion

Retirement life should mean being able to enjoy one’s savings rather than being in a perpetual state of fear of receiving tax demands, having to do calculations and facing unanticipated tax demands. Though paying taxes on one’s income from investing is unavoidable, careful planning could go a long way to reduce the amount of tax one pays on his/her mutual fund capital gains.

It is important to know the taxation structure of various investments in order to benefit from the relevant provisions and implement strategies such as taking full advantage of the annual limit for LTCG exemptions, periodic gain harvesting, booking capital losses in order to balance gains, deciding upon the Growth/IDCW and allocating your assets in a tax efficient manner.

Remember that tax planning does not necessarily mean tax evasion. The aim is to utilize the tax laws to your advantage in a proper manner. Every step matters when made for many financial years.

Prior to the end of the financial year, it would be wise to spend some time assessing your mutual fund portfolio and calculating your gains and losses in order to check whether your investments are still suitable.

IDCW (Income Distribution cum Capital Withdrawal) is an option within a mutual fund that enables an income distribution to the investors at intervals determined by the distributable surplus of the fund. The amount of distribution under IDCW will not be fixed, but rather dependent on the performance of the fund.

In the event of an IDCW payout, the NAV of the mutual fund is likely to reduce by the same amount of payout, assuming market dynamics and taxes are not considered. It is clear that IDCW cannot be considered as additional income.

Investors have an option to select between IDCW Payout and IDCW Reinvestment according to the individual schemes. While IDCW Payout makes a distribution to the investor in form of cash, IDCW Reinvestment option utilizes the declared amount in purchasing units.

To investors interested in wealth creation, IDCW is sometimes compared with the Growth option because the income is reinvested in the fund. This will all depend on what is required of the investor.

What is IDCW in Mutual Funds?

IDCW refers to a scheme of mutual funds where some of the gains earned by the mutual fund scheme are paid out to the investors periodically without getting ploughed back into the scheme.

The name IDCW came into effect due to the decision made by SEBI (Securities and Exchange Board of India) in April 2021 and replaced the previous “Dividend Option.”

It was not just another renaming done by SEBI because, through this, the regulators were trying to rectify the common misunderstanding that prevailed among the investors regarding dividend payment.

The common mistake that people made due to the name “dividend” was thinking that the mutual fund companies pay extra money to the investors like the companies give dividends. However, mutual funds do not have any extra money to pay out, and the amount of dividend paid comes from the Net Asset Value (NAV) of the scheme, i.e., what the investor invests.

Hence, the name IDCW clears everything and makes it clear that the payout made by the mutual fund scheme is a combination of:

• Income Distribution – income earned by the fund as dividends from stocks, interest from bonds or from the sale of securities in the fund’s portfolio.
• Capital Withdrawal – a withdrawal of some part of investor’s own capital.

Why “Dividend” is Changed to IDCW?

Prior to this, there was liberal usage of the term ‘dividend’ in mutual fund houses, which led to three common misconceptions:

Misconception #1 – investors thought dividend was additional income beyond their invested amount, just like in case of fixed deposits.

Misconception #2 – many felt that the fund was earning higher returns on account of the dividend, while in actuality the net asset value falls by the amount of dividend declared.

Misconception #3 – investors thought dividend payouts were assured or fixed, while it is completely dependent upon the availability of surplus in the fund at the time.

By renaming it to IDCW, SEBI hoped to clarify the process of distribution itself within the very name of the scheme. This is a retroactive process and when you check your Consolidated Account Statement (CAS), you will find your old dividend schemes renamed as IDCW.

IDCW – An Illustrative Example

To explain this in detail, we take a simple example:

Consider an investor who has invested 1,000 units of a mutual fund scheme whose current NAV is Rs. 100 per unit. That means the investment value is Rs. 1,00,000.

Now, if the scheme gives out an IDCW of Rs. 5 per unit to the investor, he gets:

IDCW Total Value = Number of Units × IDCW Per Unit = 1,000 × 5 = Rs. 5,000

But once the IDCW is given, the NAV of the scheme falls to Rs. 95 per unit (i.e., Rs. 100 − Rs. 5). The new investment value for the investor becomes:

1,000 units × Rs. 95 = Rs. 95,000

If we add the Rs. 5,000 which has been distributed, then the value remains Rs. 1,00,000, same as the previous value. The investor has received no additional wealth but just the wealth he had earlier, which has shifted from his fund investment to his bank account.

This is exactly what SEBI wished to make clear to the investors, i.e., the IDCW distribution is not some kind of a bonus.

Types of IDCW Options in Mutual Funds

In case you are investing in schemes that offer IDCW, you get to pick between the following two sub-options:

1. IDCW Payout Option

Under this option, each time the fund declares distribution, the amount gets transferred directly into your registered bank account. The option is ideal for those investors who would like a regular income from their investments in mutual funds, such as retired investors.

2. IDCW Reinvestment Option

Under this option, instead of transferring the money into your bank account, the amount gets utilized for buying additional units of the same scheme, using the current NAV. Essentially, your value of investment does not change, but instead, you are left with additional units of the scheme. The option is beneficial to those investors who do not require a steady flow of income but would like the payout amount to remain invested, indirectly earning through compounding.

It should be noted that some fund houses even give you a third option, which is known as IDCW Transfer, wherein the amount gets automatically transferred to invest in another scheme of the same fund house.

Who should go for IDCW?

IDCW mutual funds could be appropriate for investors who would like to receive regular cash payments from their investments in mutual funds, as opposed to deriving cash flows solely through unit sales. Please note that IDCW payouts are not guaranteed and cannot be seen as assured/regular income.

Please think about IDCW if:

• You require periodic cash flows: IDCW could be suitable for those investors who seek to derive some cash flow regularly.
• You are close to achieving your financial goal: If you are getting closer to achieving your objective such as retirement, etc., then IDCW may be a good choice for you.
• You want some flexibility: IDCW provides liquidity to the investor without necessitating the investor to sell units each time he/she wants to derive cash flows.
• You are aware that the payouts are not assured: IDWC will depend on the distributable surplus of the fund and the policy of the fund, and hence it cannot be equated to the interest earned on an FD.
• You have a right investment strategy: IDWC may be suitable if periodic cash payouts suit your overall financial plan.

Benefits of IDCW

Periodic Income Generation

IDCW benefits for retired individuals, homemakers, or anyone else who wants regular cash flow without withdrawing the entire amount as income include the possibility of earning income through IDWC in monthly, quarterly, or annual installments.

Liquidity without Redeeming the Entire Investment

Through IDWC, the investor has the opportunity to draw down only portions of his/her investment in small amounts at a time and keep the remaining portion invested in order not to affect the future financial plan of the individual.

Transparency in the Source of the Distributed Amount

Following the mandatory guidelines by SEBI, fund companies now have to specify whether the distributed amount is from the earned income or capital gains. The division in this way is shown in the statement and provides greater clarity.

Additional Opportunity to Invest More

Through IDWC, an investor who does not require income distribution can have additional unit allocation in the portfolio.

Helpful in Turbulent Financial Markets

In some instances, certain investors find it more desirable to earn profits on a periodic basis by receiving payments from IDCWs even during periods when the markets are volatile.

Conclusion

IDCW or Income Distribution cum Capital Withdrawal is effectively the modern form of what was once known as the “Dividend Option” in Mutual Funds. The IDCW provides investors with periodic withdrawals from the Income and Capital of the fund and thus gives investors an option to have regular cash flow, if necessary. It is important, however, to know that these withdrawals are taken from your investment value and are not additional profits.

It is important to assess your goals and tax brackets prior to choosing IDCW over the Growth Option. If income is more important for you than the compounding, then IDCW may prove to be the right investment choice. On the other hand, if you are concerned with growth rather than income, Growth Option will likely be more suitable for you.

As with any other type of investment, you should either consult a financial advisor or conduct some research on your own.