Tax harvesting is an effective way to reduce tax payments by keeping LTCG within the tax-exempt limit.
Tax-saving strategies are essential to preserving your investment returns, and tax harvesting is one highly effective method. It involves strategically selling mutual fund units to reduce your capital gains tax liability. Here’s how it works and why it’s beneficial.
Understanding Capital Gains and Taxation:
Before diving into tax harvesting, it’s important to grasp capital gains basics:
- Capital Gains: Profits made from selling investments like mutual funds.
- Short-Term Capital Gains (STCG): Gains from investments in equity mutual funds or stocks sold within a year, taxed at 20% (from 23rd July 2024) and 15% (before 23rd July 2024). For debt mutual funds, STCG is taxed based on your income slab.
. Long-Term Capital Gains (LTCG): For equity mutual funds and stocks held for over a year, gains exceeding Rs 1.25 lakh are taxed at 12.5% (from 23rd July 2024) and 10% (before 23rd July 2024).
Set-off & Carry Forward of Capital Losses:
- Short-term losses can offset both short-term and long-term capital gains.
- Long-term losses can only offset long-term capital gains.
- Certain losses (e.g., speculative) can only offset specific income types.
- Unused capital losses can be carried forward for 8 assessment years to offset future gains.
Understanding Tax Harvesting:
Tax harvesting involves selling portions of your mutual fund holdings to ensure LTCG stays under the Rs 1.25 lakh tax-exempt limit per financial year. By doing this, you avoid paying taxes on your gains while reinvesting the proceeds to maintain your investment, resetting the cost base and preventing taxes from triggering.
The Approach:
Tax harvesting requires regular monitoring of your portfolio’s growth. As your LTCG nears the Rs 1.25 lakh limit, you strategically sell portions of your holdings to remain below the threshold. After selling, you reinvest the proceeds to reset your cost base while keeping your gains tax-free.
Case Study:
Suppose you invest Rs 8 lakh in a mutual fund, and after a year, it grows to Rs 8.85 lakh, yielding a gain of Rs 85,000. Since your gains are below the tax-free threshold, you owe no taxes. Reinvest the Rs 8.85 lakh, and if it grows to Rs 9.6 lakh the following year, yielding a Rs 75,000 gain, again, no tax is due. Without tax harvesting, the Rs 1.6 lakh total gain would have exceeded the exemption, leading to taxes on Rs 35,000, costing around Rs 4,375. Tax harvesting saves this amount.
Tax-Loss Harvesting:
Tax-loss harvesting is another valuable strategy where you sell investments at a loss to offset gains from other investments, lowering your tax burden. Here’s how it works:
Suppose you invested Rs 3 lakh in a mutual fund, and its value drops to Rs 2.7 lakh, resulting in a Rs 30,000 loss. Selling the fund allows you to use the Rs 30,000 loss to offset gains from other investments. If your loss exceeds your gains, you can carry it forward for up to 8 years to offset future gains.
For instance, if you earn Rs 1.7 lakh in capital gains, exceeding the tax-free limit by Rs 45,000, you can apply the Rs 30,000 loss to reduce your taxable gain to Rs 15,000, reducing your tax liability.
Tax-loss harvesting is also helpful for cleaning up underperforming assets while ensuring tax efficiency. By reinvesting, you maintain market exposure and continue to grow your wealth.
Reflecting on Tax Harvesting:
Tax harvesting is an effective way to reduce tax payments by keeping LTCG within the tax-exempt limit. It is especially advantageous for investors with large portfolios, as it allows portfolio rebalancing without incurring taxes. Furthermore, tax harvesting helps control gains by spreading them across financial years, reducing tax liabilities. Both tax gain and loss harvesting are simple yet powerful strategies that optimize returns, as long as you re invest immediately to continue benefiting from compounding.
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This blog is purely for educational purposes. Mutual fund investments are subject to market risks, read all scheme-related documents carefully.
