Why rebalancing your MF portfolio is crucial; how tax rules could eat into your returns
As markets swing, your mutual fund portfolio can drift from its original goals and risk profile. Rebalancing helps restore your intended asset mix—but many investors overlook the tax traps hidden in this process. Knowing how taxes apply to portfolio switches is crucial for protecting your long-term returns.
- Jun 28, 2025,
- Updated Jun 28, 2025 11:06 AM IST
As markets rise and fall, mutual fund portfolios rarely remain static. Even the most carefully designed investment mix can drift away from an investor’s original goals and risk appetite over time. That’s why portfolio rebalancing — the practice of resetting your investments to their intended asset mix — is crucial to staying on track.
When experts talk about rebalancing an investment portfolio, they mean restoring it to the original asset allocation an investor set out with. “Rebalancing a mutual fund portfolio refers to the process of realigning the asset allocation, such as equity, debt, or hybrid funds to stay in line with one’s financial goals, risk appetite, and prevailing market conditions,” said CA Suresh Surana.
An investment portfolio is typically constructed with various asset classes such as equity, debt or fixed income, real estate, and gold, in specific proportions. These proportions are determined by factors like financial goals, investment horizon, risk tolerance, and anticipated returns from different asset classes.
However, as markets move, certain asset classes may outperform while others lag. For example, a rally in equities might push an investor’s equity allocation higher than intended, increasing overall portfolio risk. Rebalancing involves selling a portion of assets that have grown disproportionately and investing the proceeds into asset classes whose weightings have fallen. This restores the original allocation and keeps risk under control.
If an investor started the year with a 60:40 split between equities and fixed income, a surge in equities could shift the mix to 70:30. Rebalancing would then require selling some equity funds and channeling those funds into fixed income to bring the allocation back in line.
Year-end is often a good time to review and rebalance portfolios. Yet, while rebalancing is essential for disciplined investing, investors must not overlook the tax implications. “While this is a common and prudent investment strategy, it’s important to note that the Income Tax Act, 1961 does not provide any specific definition or exemption for rebalancing transactions,” Surana pointed out.
Any transaction involving redemption of mutual fund units—even if reinvested into another fund within the same asset management company (AMC)—is considered a taxable event under the Income Tax Act. Essentially, switching equals redemption, which equals capital gains tax.
Surana explained that switches can take various forms: moving from regular to direct plans, changing between growth and dividend options, or shifting between different schemes within the same AMC. “The taxpayer is therefore liable to pay capital gains tax, either short-term or long-term, depending on the holding period and the type of mutual fund sold,” he said.
Dinkar Sharma, Company Secretary and Partner, Jotwani Associates, said: “Rebalancing your mutual fund portfolio—when done manually by redeeming and switching between schemes—can trigger capital gains tax. For equity funds, long-term capital gains (holding period over one year) above ₹1 lakh are taxed at 10%, and short-term gains are taxed at 15%. Debt mutual funds, post the 2023 amendment, are now taxed at slab rates regardless of the holding period, as the indexation benefit has been removed.”
He added: “However, if rebalancing is done within a single fund—such as a balanced or dynamic asset allocation fund—no tax is triggered at the investor’s end. Therefore, passive rebalancing within funds can be more tax-efficient for long-term investors. One should always consider the tax impact while planning portfolio adjustments.”
Certain exemptions exist under Section 47 of the Income Tax Act. “Specifically, Section 47(xviii) provides exemption in cases where a mutual fund consolidation takes place within a scheme of the same fund house, i.e., units of a consolidating scheme are transferred to a consolidated scheme. Similarly, Section 47(xix) exempts the transfer of units in a consolidating plan to a consolidated plan within the same mutual fund scheme. These exemptions are applicable only when the rebalancing involves specific plan or scheme mergers approved by SEBI. Outside of these defined scenarios, any rebalancing transaction involving redemption or switching of units is liable to capital gains tax as per applicable provisions,” Surana added.
Ultimately, while rebalancing helps maintain discipline and manage risk, investors should carefully weigh tax implications to ensure their portfolio adjustments don’t erode long-term returns.
As markets rise and fall, mutual fund portfolios rarely remain static. Even the most carefully designed investment mix can drift away from an investor’s original goals and risk appetite over time. That’s why portfolio rebalancing — the practice of resetting your investments to their intended asset mix — is crucial to staying on track.
When experts talk about rebalancing an investment portfolio, they mean restoring it to the original asset allocation an investor set out with. “Rebalancing a mutual fund portfolio refers to the process of realigning the asset allocation, such as equity, debt, or hybrid funds to stay in line with one’s financial goals, risk appetite, and prevailing market conditions,” said CA Suresh Surana.
An investment portfolio is typically constructed with various asset classes such as equity, debt or fixed income, real estate, and gold, in specific proportions. These proportions are determined by factors like financial goals, investment horizon, risk tolerance, and anticipated returns from different asset classes.
However, as markets move, certain asset classes may outperform while others lag. For example, a rally in equities might push an investor’s equity allocation higher than intended, increasing overall portfolio risk. Rebalancing involves selling a portion of assets that have grown disproportionately and investing the proceeds into asset classes whose weightings have fallen. This restores the original allocation and keeps risk under control.
If an investor started the year with a 60:40 split between equities and fixed income, a surge in equities could shift the mix to 70:30. Rebalancing would then require selling some equity funds and channeling those funds into fixed income to bring the allocation back in line.
Year-end is often a good time to review and rebalance portfolios. Yet, while rebalancing is essential for disciplined investing, investors must not overlook the tax implications. “While this is a common and prudent investment strategy, it’s important to note that the Income Tax Act, 1961 does not provide any specific definition or exemption for rebalancing transactions,” Surana pointed out.
Any transaction involving redemption of mutual fund units—even if reinvested into another fund within the same asset management company (AMC)—is considered a taxable event under the Income Tax Act. Essentially, switching equals redemption, which equals capital gains tax.
Surana explained that switches can take various forms: moving from regular to direct plans, changing between growth and dividend options, or shifting between different schemes within the same AMC. “The taxpayer is therefore liable to pay capital gains tax, either short-term or long-term, depending on the holding period and the type of mutual fund sold,” he said.
Dinkar Sharma, Company Secretary and Partner, Jotwani Associates, said: “Rebalancing your mutual fund portfolio—when done manually by redeeming and switching between schemes—can trigger capital gains tax. For equity funds, long-term capital gains (holding period over one year) above ₹1 lakh are taxed at 10%, and short-term gains are taxed at 15%. Debt mutual funds, post the 2023 amendment, are now taxed at slab rates regardless of the holding period, as the indexation benefit has been removed.”
He added: “However, if rebalancing is done within a single fund—such as a balanced or dynamic asset allocation fund—no tax is triggered at the investor’s end. Therefore, passive rebalancing within funds can be more tax-efficient for long-term investors. One should always consider the tax impact while planning portfolio adjustments.”
Certain exemptions exist under Section 47 of the Income Tax Act. “Specifically, Section 47(xviii) provides exemption in cases where a mutual fund consolidation takes place within a scheme of the same fund house, i.e., units of a consolidating scheme are transferred to a consolidated scheme. Similarly, Section 47(xix) exempts the transfer of units in a consolidating plan to a consolidated plan within the same mutual fund scheme. These exemptions are applicable only when the rebalancing involves specific plan or scheme mergers approved by SEBI. Outside of these defined scenarios, any rebalancing transaction involving redemption or switching of units is liable to capital gains tax as per applicable provisions,” Surana added.
Ultimately, while rebalancing helps maintain discipline and manage risk, investors should carefully weigh tax implications to ensure their portfolio adjustments don’t erode long-term returns.