Budget 2026: Why the ₹12-Lakh ‘Zero Tax’ Promise Falls Short for Mutual Fund Investors
Union Budget 2026–27 draws closer, the expectations are rising among taxpayers, common men in particular, that the income tax provisions would be honed to provide real relief. The promise of “zero tax” for the individual earning up to ₹12 lakh under the new system has had everyone excited, but a closer look tells us a different story.
Current tax rules on capital gains may have the opposite effect of diluting the relief that is supposed to be coming through, for lakhs of middle-class Indians who invest in equity mutual funds as a tool for long-term wealth creation. As tax experts and industry bodies raise flags, Budget 2026 could serve as an inflection point to re-imagine the way long-term investments are taxed.
The Allure of the Zero Tax Bracket, and the Fine Print
In the previous Union Budget, Finance Minister Nirmala Sitharaman had said those earning up to ₹12 lakh a year, as per the new tax system, would pay no tax. That may have sounded like across-the-board relief, but remember this isn’t a benefit available to everyone.
The zero tax outcome is possible due to a rebate under Section 87A of the Income Tax Act, which provides for a rebate of up to ₹60,000 per financial year. This discount directly offsets tax payable, but only for income taxed at normal slab rates. It does not cover income taxed at special rates, LTCG and STCG.
This gray area has increasingly become a big bone of contention with equity mutual fund investors who are way below ₹12 lakh but have to pay tax on the capital gains.
Why Mutual Fund Investors Were Left Out of Section 87A
Before the changes announced under the Union Budget 2025, the discount offered in Section 87A could also be applied against some types of capital gains, mostly those from non-equity assets. Post the reform, capital gains attracting special tax rates like equity LTCG and STCG are out of the rebate’s purview.
That means a taxpayer who earns less than ₹12 lakh but books gains from an equity mutual fund can still be required to pay tax. This issue has made the Association of Mutual Funds in India (AMFI) and numerous tax professionals call for change.
AMFI has written to the government seeking an amendment in Section 87A that will make it possible to claim the ₹60,000 rebate after calculating tax on special-rate incomes if the total income, including capital gains, does not exceed ₹12 lakh. “A more pertinent question is whether proposals such as these are in line with the government’s objective of promoting savings and long-term investment amongst the middle class,” AMFI said.
LTCG Tax: Higher Rate, Limited Relief
Another area under scrutiny is the structure of the long-term capital gains tax itself. Tax on LTCG in the context of equity investment was raised to 12.5 per cent under Section 112A by the government through the Union Budget 2024, and, at the same time, it upped down the maximum exempted amount from ₹1 lakh to ₹1.25 lakh.
Though the higher exemption was greeted with praise, experts contend that it is still insufficient for some investors who maintain their investment positions for five to seven years or more.
SK Patodia & Associate LLP Associate Director of Direct Tax Mihir Tanna says, “For committed long-term investors, breaching the ₹1.25 lakh profitable slab is far from uncommon, so much so that in real terms it renders this year’s exemption inadequate. The present LTCG tax regime provides for a ₹1.25 lakh profits shield, but herein lies the rub: committed long-term players who systematically accumulate shares over time are usually not daunted if they breach this threshold at all,” he adds.
Pankaj Kapoor, CA at NMIMS Chandigarh, points out that the limit has not been immediately indexed for cost-inflation, or behind long term wealth creation, dramatically affecting its efficacy towards middle-income families.
What This Means for the Middle Class
A double whammy from the low LTCG exemption limit and exclusion of Section 87A rebate has hit small and middle-class investors extra hard. Many whose capital gains are only marginally above ₹1.25 lakh have to pay 12.5% tax even at the trough just because they fall below the threshold level of ₹12 lakh.
Equity mutual funds are long-term investment vehicles meant for children’s education, buying a house or retirement planning,” says tax experts. But when they cash in those investments in times of trouble, many find that money they thought was “tax-free” is not tax-free at all.
This creates a fear that under such a structure, taxation can act as an obstacle to increasing contribution by equity at a time when the government is pushing for financialization of savings.
A Real-Life Tax Illustration
Jignesh Shah, Partner – Direct Tax at Bhuta Shah & Co, explains the anomaly through a practical example. Consider a taxpayer earning a total income of ₹8 lakh.
If the income consists only of salary, the individual can fully utilize the Section 87A rebate and pay zero tax. However, if part of that income includes long-term capital gains from equity mutual funds, the outcome changes significantly.
For instance, a person earning ₹6 lakh as salary and ₹2 lakh as LTCG will have to pay tax on gains exceeding the ₹1.25 lakh exemption. Since Section 87A does not apply to LTCG, the individual ends up with a tax liability, even though total income remains well within the ₹12 lakh limit.
This example clearly demonstrates how capital gains can push taxpayers into paying tax despite qualifying for “zero tax” under the new regime.
What the experts want from Budget 2026
With Budget 2026–27 imminent, tax professionals and industry bodies are optimistic of some resolution to these anomalies. The important suggestions include bringing income which was being taxed at special rates, i.e. LTCG and STCG, into the purview of rebate under section 87A, provided total income is ₹12 lac or below, etc.
Experts have also proposed increasing the LTCG exemption limit above ₹1.25 lakh or index-linking it to inflation. Such a change would better capture real investment growth and bring tax policy in line with the government’s long-term savings theme.
According to AMFI, the existing framework would dissuade middle-class investors from employing mutual funds as a wealth-generation tool.
Budget 2026-27: A Defining Test
With high expectations from the Union Budget 2026–27, treatment of capital gains and tax rebates will be the focus point. Execution shortcomings, as much as the government intends to provide relief on the tax front for the middle income, there are execution gaps that have left a large number of equity investors feeling given short shrift.
If the forthcoming Budget fills this gap by rationalizing LTCG exemptions and widening the ambit of Section 87A, it will decide whether or not PM Modi’s “zero tax promise” translates into actual relief for middle-class Indian investors.
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