Most Indians assume that because India does not have an inheritance tax, investments passed on to children or family members are largely tax-free. But that is only partly true. A new analysis by Value Research highlights a surprising reality: the tax treatment of inherited wealth can vary dramatically depending on the investment product.
According to the analysis, a nominee inheriting a ₹3.5 crore mutual fund portfolio could eventually face a tax bill of nearly ₹39 lakh, while someone inheriting an equally sized NPS corpus may pay zero tax on the lump-sum amount.
The difference lies in how the tax system treats inherited mutual funds versus the National Pension System (NPS).
When someone inherits mutual funds, the inheritance itself is not taxed. However, the nominee also inherits the original purchase cost and holding period of the investor. This means the accumulated gains over decades continue to exist for tax purposes.
For example, suppose an investor built a mutual fund portfolio worth ₹3.5 crore over 30 years through SIP investments of roughly ₹36 lakh. The nominee who later redeems the investment may have to pay long-term capital gains tax on almost the entire appreciation.
According to Value Research’s calculations, the unrealised gain in such a scenario could be around ₹3.14 crore. After adjusting for the annual exemption limit of ₹1.25 lakh, the remaining gains would be taxed at 12.5 per cent, creating a tax liability close to ₹39 lakh.
Importantly, the tax is not triggered immediately after inheritance. It becomes payable when the nominee eventually sells or redeems the mutual fund units.
“Section 49(1) says the heir inherits the original purchase cost. Section 2(42A) says the heir inherits the original holding period. The nominee’s clock did not start the day they received the units. It started the day the deceased bought them.
When the nominee redeems, capital gains tax applies on the full appreciation since the original purchase date. For equity funds, that means 12.5 per cent long-term capital gains tax on gains above Rs 1.25 lakh in a financial year,” said Aakar Rastogi of Value Research.
“This is the tax tail. Decades of compounded appreciation are compressed into a single tax event when the nominee chooses to sell. Capital gains tax on equity is deferred, never eliminated,” Rastogi added.
NPS, however, works very differently.
Under provisions introduced through the Finance Act 2016, the entire NPS corpus received by a nominee after the subscriber’s death is fully tax exempt if taken as a lump sum. That means no capital gains tax applies and the nominee does not inherit decades of accumulated taxable appreciation.
In practical terms, if the same ₹3.5 crore corpus were held inside an NPS account instead of mutual funds, the nominee could potentially receive the entire amount tax-free.
There is, however, an important caveat. If the nominee uses the inherited NPS money to purchase an annuity, the pension income generated later becomes taxable according to the individual’s income slab.
The analysis does not suggest that investors should replace mutual funds entirely with NPS. Both products serve very different purposes.
Mutual funds continue to offer far greater liquidity, flexibility and unrestricted access to money. Investors can redeem at any time, increase or decrease allocations freely and maintain higher equity exposure.
NPS, on the other hand, comes with retirement-linked restrictions including lock-ins, withdrawal conditions and limits on equity allocation.
” For wealth meant to pass to the next generation, NPS plays a role that no general-purpose equity asset can. It is the only equity-exposed Indian product that passes to the nominee with no tax tail. PPF and EPF do the same work for the fixed-income slice.
The case for NPS is usually argued on the basis of the Rs 50,000 deduction under Section 80CCD(1B). That is the small argument. The large argument is what happens to your nominee on the day they sell,” said Rastogi.
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