If the redemption of mutual fund units are done within an year of investment, 20% tax gets applied on the profit or gain. The gain here is termed as STCG or Short Term Capital Gain.
If the redemption of mutual fund units are done after one year of investment, 12.5% tax gets applied on the profit or gain after exempting ₹ 1.25 Lakhs of gain. The gain here is termed as LTCG or Long Term Capital Gain.
To utilize the exemption of ₹ 1.25 lakhs on LTCG, if there is investment older than 1 year, an investor can redeem mutual fund units upto gain of ₹ 1.25 lakhs, and reinvest the same.
Let’s understand this with an example. Suppose an investor had investment of ₹ 4 lakhs done last year or before that. The investment has completed 1 year period, and it has grown to 6 lakhs. The gain here is LTCG or Long Term Capital Gain. So, tax of 12.5% will be applied here after exempting ₹ 1.25 lakhs, if redemption is done.
The investor here can redeem units to an amount close to ₹ 5 lakhs, ensuring that the profit booked is ₹ 1.25 lakhs. The profit booked can be reinvested, and after reinvestment, the profit will not be considered as gain but as amount invested which is non taxable.
In this way, an investor can save ((12.5% of ₹ 1.25 lakhs) + 4% cess) every year which is equal to ₹ 16500 tax every year.
Even in a bad scenario, if the market falls by 1 or 2 percent on the day of reinvestment as compared to redemption, investor would still save at least ₹ 15000 on tax.
This strategy is helpful even in case you are stuck in a fund which is underperforming for a long time, and you need to exit the fund to reinvest in some other fund.