Mutual Funds vs. ETFs: Which saves you more Tax after the 2026 Reform?

The transition from the Income Tax Act, 1961, to the Income Tax Act, 2025, represents the most profound restructuring of Indian tax law in over six decades. Effective April 1, 2026, this reform aims to reduce the “complexity burden” that had made Mutual Funds vs. ETFs a difficult calculation for the average investor. The new Act replaces 819 sections with 536 streamlined clauses, focusing on “plain language” and digital-first compliance.   

For professional investors, the most critical conceptual shift is the replacement of the dual “Assessment Year” and “Previous Year” with a unified “Tax Year”. This aligns the earning period directly with the filing period, removing the historical confusion regarding which budget’s rules apply to a specific redemption event. As we evaluate Mutual Funds vs. ETFs, we must view them through the lens of this “New Tax Year” framework, where certainty and transparency are the primary objectives of the revenue authorities.   

The New Income Tax Act 2025/26: A Simplified Regime

The core philosophy of the 2026 reform is the elimination of disparate tax treatments for similar asset classes. Historically, different types of mutual funds were subject to varying holding periods (12, 24, or 36 months) and indexation rules. The Income Tax Act, 2025, harmonizes these into two primary holding periods: 12 months for all listed securities (including ETFs and equity mutual funds) and 24 months for all unlisted assets.   

This simplification means that the choice of Mutual Funds vs. ETFs is no longer about finding a niche category with a shorter tax clock. Instead, the government has incentivized long-term holding by setting a unified 12.5% LTCG rate across the board. However, this “concessional” rate comes at a cost: the total removal of indexation, which fundamentally changes the math for debt and commodity-oriented funds.

The Death of Indexation: Why the Shield is Gone

For decades, indexation was the “shield” that protected long-term investors from paying tax on gains that were merely the result of inflation. By adjusting the purchase price using the Cost Inflation Index (CII), an investor could often report a “real” gain that was significantly lower than the “nominal” profit.   

In the 2026 regime, this shield has been discarded for all new investments made after April 1, 2023. When comparing Mutual Funds vs. ETFs in the debt or gold space, the absence of indexation means you are now taxed on the absolute profit. If you bought an asset for ₹100 and sold it for ₹150 after five years, you will pay 12.5% on the full ₹50 gain, regardless of how much inflation rose during that period.   

This “Death of Indexation” makes Mutual Funds vs. ETFs a battle of alpha generation and cost control. Active fund managers can no longer rely on indexation to make their post-tax returns look attractive. Investors must now seek out vehicles that minimize every possible basis point of cost to ensure that their nominal gains stay ahead of both inflation and the flat 12.5% tax.

Equity-Oriented Analysis: Mutual Funds vs. ETFs

In the equity market, the Mutual Funds vs. ETFs debate is now centered on the revised Section 112A. The holding period for long-term classification remains at 12 months, provided the fund maintains at least 65% exposure to domestic equities.   

The ₹1.25 Lakh Exemption: A Limited Relief

The increase of the annual LTCG exemption limit to ₹1.25 Lakh (up from ₹1 Lakh) is designed to protect small retail investors. However, for the serious wealth-builder, this threshold is easily breached. Consider a portfolio of ₹50 Lakh growing at 12% per year; the annual gain of ₹6 Lakh would leave ₹4.75 Lakh taxable at 12.5%.   

The Rise of the 20% STCG Rate

Short-term traders face a harsher environment in 2026. The STCG rate for equity-oriented Mutual Funds vs. ETFs has been hiked to 20%. This 20% tax acts as a significant deterrent to tactical “churning” of portfolios. It further reinforces the structural advantage of ETFs, which are designed for long-term “buy-and-hold” index tracking rather than the frequent internal stock-flipping often seen in actively managed mutual funds.

The Hidden Tax: Why Expense Ratios are the New Tax Bracket

If the explicit tax rate for Mutual Funds vs. ETFs is now unified at 12.5%, where does the differentiation lie? The answer is the Total Expense Ratio (TER)—what financial consultants often call the “Hidden Tax.”   

Active large-cap mutual funds in India typically carry a TER of 1.0% to 2.0%. In contrast, a Nifty 50 ETF can be held for as little as 0.04% to 0.10%. While a 1.5% difference might seem minor in a single year, the compounding effect over a 20-year horizon is staggering. Expert analysis suggests that an investor in a high-cost mutual fund could lose up to 23-25% of their terminal wealth purely to management fees compared to an ETF investor.   

In the 2026 landscape, where you already lose 12.5% to the government, paying another 1.5% to a fund manager—who, statistically, has a 65-73% chance of underperforming the index in the large-cap space—is a strategic risk that is increasingly hard to justify.

Tracking Error vs. Exit Loads: The Liquidity Cost Factor

The true cost of an investment is not just what you pay while holding it, but what you pay to leave it. This is where the Mutual Funds vs. ETFs choice becomes a trade-off between “Exit Loads” and “Liquidity Friction.”   

The 1% Exit Load Barrier

Most equity mutual funds impose an exit load of 1% if units are redeemed within 12 months. This 1% is a direct deduction from your redemption value, meaning it acts as a 1% penalty on your total capital, not just your profits. For a ₹10 Lakh redemption, an exit load of ₹10,000 could be higher than the actual capital gains tax owed.   

ETFs and the “Impact Cost”

ETFs have no exit loads, but they are subject to Impact Cost—the difference between the ideal price (NAV) and the actual execution price on the exchange. In highly liquid ETFs like the Nippon India ETF Nifty 50 BeES, the impact cost is generally negligible (often below 0.05%) for retail volumes. However, in times of market stress or in niche sectoral ETFs, the impact cost can rise, effectively acting as a variable exit fee. For the long-term investor, the near-zero TER and absence of exit loads in ETFs usually provide a superior post-tax outcome compared to the guaranteed exit load of a mutual fund.

Dividend Taxation: The End of Interest Deductions

A significant “stealth” change in the Income Tax Act, 2025, relates to how dividends are taxed. Since 2020, dividends from both Mutual Funds vs. ETFs have been taxable at the investor’s marginal slab rate. However, a specific deduction previously existed under Section 57 (and now Section 93 of the 2025 Act), allowing investors to deduct up to 20% of their dividend income as interest expenditure if they had borrowed money to invest.   

The 2026 Budget has officially revoked this deduction.

Effective from the Tax Year 2025-26, no deduction shall be allowed for any interest expenditure incurred in relation to dividend income or income from mutual fund units.   

For high-income investors in the 30% or 39% brackets, this makes the “Growth” option the only viable choice. By choosing the Growth option, you avoid the slab-rate tax on dividends and instead pay the much lower 12.5% LTCG rate when you eventually sell the units. The “IDCW” (Dividend) option is now a significant tax trap for anyone in a tax bracket higher than 12.5%.

Special Comparison Table: 2026 Tax Framework

Feature	Equity Mutual Fund	Equity ETF	Debt Mutual Fund	Gold ETF	International Fund
Holding Period for LTCG	> 12 Months	> 12 Months	N/A (Always STCG)	> 12 Months	> 24 Months
Tax Rate (Long-Term)	12.5%	12.5%	Slab Rate	12.5%	12.5%
Tax Rate (Short-Term)	20%	20%	Slab Rate	Slab Rate	Slab Rate
Indexation Benefit	None	None	None	None	None
₹1.25 Lakh Exemption	Yes (Aggregate)	Yes (Aggregate)	No	No	No
Exit Load	Typically 1%	None	0.25% – 1%	None	1%
Typical TER	0.70% – 2.0%	0.04% – 0.25%	0.30% – 0.80%	0.50% – 0.80%	0.60% – 1.70%

Commodity Advantage: The Gold ETF Arbitrage

One of the most surprising outcomes of the 2026 reform is the tax advantage given to Gold and Silver ETFs over Gold Mutual Funds.

• Gold ETFs: Because they are listed on the exchange, they qualify as long-term capital assets after only 12 months.
• Gold Mutual Funds (FoFs): Because they are typically unlisted “units of a fund,” they require a 24-month holding period to qualify for the same 12.5% LTCG rate.   

This creates a clear 12-month arbitrage window. An investor using a Gold ETF can rebalance their portfolio and lock in the lower 12.5% tax rate a full year earlier than someone using a Gold Mutual Fund. In a volatile market, this 12-month liquidity advantage is critical for tactical asset allocation.

NRIs and Global Portfolios: TCS and Currency Factors

Non-Resident Indians (NRIs) face a different set of constraints in the Mutual Funds vs. ETFs debate. While the LTCG rate for NRIs is also 12.5%, they do not benefit from the ₹1.25 Lakh exemption, which is reserved for residents.   

The TCS Lock-up

For residents investing in international ETFs (like those tracking the S&P 500), the 20% Tax Collected at Source (TCS) remains a major hurdle for remittances above ₹7 Lakh. This 20% is not a final tax—it is refundable—but it represents a significant liquidity lock-up that can last for over a year.   

The Rupee Depreciation Tailwind

Expert analysis shows that over the last 20 years, the Rupee has depreciated by approximately 3.4% annually against the Dollar. For an NRI or a global investor, this currency movement acts as a built-in return booster. In the 2026 regime, choosing a domestic Indian ETF that tracks an international index (like the Motilal Oswal NASDAQ 100 ETF) allows you to capture this currency tailwind without the 20% TCS friction associated with direct foreign remittances.

Advanced Strategies: Loss Harvesting in the 2025 Framework

The Income Tax Act, 2025, has reinforced the strict silos for capital loss set-offs, reverting to the framework of the 1961 Act after a brief proposed relaxation was withdrawn.   

1. Long-Term Capital Losses (LTCL): Can only be set off against Long-Term Capital Gains.   
2. Short-Term Capital Losses (STCL): Can be set off against both STCG and LTCG.   

In the Mutual Funds vs. ETFs choice, ETFs are far superior for “Tax Loss Harvesting.” Because ETFs trade in real-time, you can sell a loss-making position and immediately buy a similar (but not identical) ETF to maintain your market exposure while “booking” the loss for tax purposes. With mutual funds, the 1-2 day settlement cycle and end-of-day NAV pricing make precise loss harvesting much riskier, as you could be “out of the market” during a sudden recovery.

Tax-Efficiency Checklist for 2026

• [ ] Harvest your ₹1.25 Lakh limit: Ensure you realize at least ₹1.25 Lakh in LTCG every year to take full advantage of the tax-free threshold.   
• [ ] Audit your Expense Ratios: If your large-cap fund charges >1%, consider switching to a Nifty 50 ETF with a 0.05% TER.
• [ ] Transition Legacy Debt: Review debt funds bought before April 2023. They still hold a 12.5% LTCG advantage if held for >24 months.   
• [ ] Exit Dividend Plans: Switch all “IDCW” holdings to “Growth” to avoid the slab-rate tax trap and the loss of interest deductions.   
• [ ] Use ETFs for Tactical Commodity Plays: For gold or silver exposure, use ETFs to lock in long-term tax rates in half the time of a mutual fund.
• [ ] Monitor Section 50AA: Ensure your hybrid funds haven’t slipped below 65% equity, or they will be taxed at your full slab rate.

Conclusion: The Strategic Outlook for 2026

The 2026 Tax Reform signals the end of the “alpha-through-complexity” era in Indian investing. By simplifying the code into the Income Tax Act, 2025, the government has shifted the burden of performance squarely onto the fund managers.

In the battle of Mutual Funds vs. ETFs, the structural advantages of the ETF—transparency, liquidity, and rock-bottom costs—have made it the clear winner for the core of any modern portfolio. While active mutual funds still have a role in the less efficient mid-and-small-cap segments, the 2026 regulatory framework confirms that for large-cap and commodity exposure, the passive route is the most tax-resilient path forward.

For investors looking to capitalize on specific policy shifts, choosing the right theme is now more critical than ever. Check out our guide on the Best Sector ETFs after Budget 2026: Top 10 Picks for Retail Investors to see which industries are positioned to lead this new era.

As you rebalance your holdings for the upcoming Tax Year, remember that in a simplified tax regime, your greatest competitive advantage is the elimination of unnecessary costs. For the latest circulars and official notifications regarding these legislative changes, you can visit the official Income Tax Department of India portal.

Don’t let high fees and outdated tax strategies erode your wealth. Consult a tax-specialized financial advisor today to transition your portfolio to the 2026 framework.