Should you switch from regular to direct mutual funds?

I have a few regular mutual fund SIPs. Since direct plans give more returns, should I stop regular plans and start direct plans in their place? - Shailendra Pathak

Regular plan and direct plan - these are the two variants of every mutual fund scheme.

Contrary to a direct plan, a regular mutual fund plan is one in which you invest in a mutual fund scheme through an intermediary (distributors or brokers). These intermediaries handhold you in the process of mutual fund investing, assist you in the paperwork while making transactions, offer expert guidance, among many other things.

In a direct plan, you are devoid of any such assistance from intermediaries since you purchase mutual funds directly from the AMC or fund house. Although direct plans give higher returns (due to relatively less expense ratio charged) than their regular plan counterparts, investors are advised to choose them if they have a thorough understanding of different mutual fund schemes and do not need any assistance.

But wait! There's more.

If you are still planning to switch from a regular plan to a direct plan, there are three more factors that should be worth your consideration.

1. Lock-in period
Only after the lock-in period of the regular plan has ended, can you switch to its direct plan. Equity-linked savings schemes (ELSS) have a mandatory lock-in period of three years. One cannot switch from a regular to a direct plan, even of the same scheme during the lock-in period. Likewise, certain solution-oriented schemes like retirement and children-specific funds may have a lock-in period of up to five years during which the switch/redemption cannot be made.

Also, be mindful of the investments that are made via SIPs. The lock-in period is calculated from the date of each instalment separately. An SIP in an ELSS fund (with three-year lock-in) in September 2019 will be free of the lock-in in September 2022. Thus, each SIP instalment has to complete three years before it is free of the lock-in period. When you make the switch to a direct plan, the lock-in period will start over again on the new investment.

2. Exit load
Most equity mutual fund schemes penalise the investor, in the form of an exit load on an early withdrawal. An exit load can be a certain percentage of the NAV that is deducted at the time of redemption. Usually, it is levied if the investment is redeemed within a year from an equity fund.

If you've invested in a regular plan via an SIP, the exit load period is calculated from the date of each monthly instalment. And, when you switch to the direct plan, it is considered a new purchase and the new exit load tenure will begin from the date of the investment. So ensure that redeeming your funds does not attract an exit load.

3. Taxation
When you switch from a regular plan to a direct plan, for taxation purposes it will be considered first as a redemption from the existing (regular) scheme and then as a fresh investment in the new (direct) scheme. So redeeming units of a regular mutual fund scheme will attract capital gains tax. Understand how your mutual fund gains are taxed.

As in the case of new investments made to the direct plans, the lock-in periods and exit loads, the tenure to qualify for the capital gains will start over from the date of investment in the direct plan. Do keep this in mind to avoid unnecessary tax outflows due to tax implications.

Suggested watch: Pros and cons of shifting from regular to direct plans