Putting all investments in a mutual fund in a single folio can negatively affect post-tax returns. I learnt this the hard way.

All mutual fund redemptions in India follow the First-In-First-Out (FIFO) principle i.e., at the time of withdrawal, the earliest investments in the folio get redeemed first. Always.

FIFO redemption may seem harmless, but it creates two problems:

Higher taxes on redemption
If your earliest investments (SIP or lump-sum) were made recently enough that the gains do not qualify as long-term capital gains (LTCG), you will have to pay higher taxes on the short-term capital gains (STCG).

Frequent investments and redemptions in the same folio prevent the oldest investments from becoming eligible for LTCG.

Tax-efficient harvesting of short-term losses becomes infeasible
If a SIP has been ongoing for some time, the folio will likely contain a mix of long-term gains as well as short-term gains and (or) losses. Harvesting short-term losses is an excellent way to save on taxes by deferring them to the future .

However, booking short-term losses also leads to the portion with long-term gains getting sold along due to the FIFO redemption. The sale makes the LTCG tax immediately payable, reducing the long-term returns because of the lost opportunity to defer taxes.

Way Around

A simple and effective work around these issues caused by FIFO redemption is to separate the investments into multiple folios: investments that are more than a few months apart should be put in separate folios. SIPs should be redirected into a new folio every 3-4 months. Similarly, a new folio should be created for each large lump-sum investment, such as the annual bonus.

Over time, some of your folios would accumulate only long-term gains (or losses), while others only short-term gains (or losses). The resulting clean segregation would make it easier to do tax harvesting.

When in need of money, you can choose to redeem from either a) the old folios with only long-term gains or b) the most recent ones which would be too far from reaching LTCG threshold. The selective redemption would leave the investments in the middle of the spectrum — old-but-not-old-enough — untouched and let them mature to qualify for LTCG.

Having different folios also makes it easier to identify which investments are ripe for tax harvesting, or can be used for rebalancing.

There is nothing special about a new folio number per se: you can reuse a folio from which all investments have been redeemed. But restarting investments in a non-empty folio after a gap period can again lead to mixing of gains and losses.

Downsides

To be fair, maintaining several folios is not without downsides: tracking of investments becomes a little hard, and changing SIPs every few months requires minor but additional effort.

Creating and managing multiple folios may have been quite difficult in the past (during the era of physical cheques and transaction forms) but modern online platforms, such as Kuvera, make the task much easy now. My own investments, for instance, are spread across 10+ equity folios, and 5-6 debt folios.

If the number of folios ever start to become unmanageable, you can consider merging the ones that have crossed the LTCG threshold. The process is quick and easy, requiring just a few clicks on the MF Central Portal.