Hidden tax cost of switching mutual funds to direct plans

Direct and regular plans carry different ISINs, making them separate investments for tax purposes. A switch between Growth and IDCW options also triggers a tax event, since each option has its own ISIN. Any capital gain on the redemption is taxable in the year of the switch, Kumawat said. The tax treatment holds whether the switch happens through an investment platform, a broker, or directly via the asset management company.

Consider a lump-sum investment of ₹1 lakh in a regular large-cap fund with a 1% expense ratio, versus 0.5% for the direct version. After two years at 10% average annual return before expenses, the direct plan's NAV would outpace the regular plan's by roughly the expense differential, compounded. But the tax on the redemption – short-term or long-term capital gains, depending on holding period – can eat into that advantage.

Kumawat noted there are multiple factors to consider, so the decision should not be based only on the expense ratio.

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