Is Tax Harvesting a Good Strategy to Optimise Your Returns?

Introduction

They say changes and taxes are the only constant. Tax harvesting is one of the several methods through which you can lower your tax outgo. So, what is tax harvesting and its various aspects? Let us find out.

Understanding Capital Gains, Capital Assets, and Mutual Fund Taxation

Before understanding the concept of tax harvesting, you must have a holistic understanding of capital gains and capital assets. Capital assets are assets that you hold for investment purposes. Some examples of capital assets include stocks and mutual funds. Capital gains arise when you sell them and make profit. Based on the asset’s holding period, capital gains are classified into:

• Long-term capital gains (LTCG)

If you sell your capital assets after a year of investing, the gains qualify as long-term capital gains. In the case of equity mutual funds and stocks, you pay an LTCG tax of 12.5% on profits made above ₹1.25 lakh in a year. For example, if you invest ₹1 lakh in an equity mutual fund and after a year, your investment swells to ₹1.30 lakhs, you need to pay a 12.5% LTCG tax on ₹5,000 (₹1.30 lakh - ₹1.25 lakh).

• Short-term capital gains (STCG)

If you sell your capital assets within a year of investing, the gains qualify as short-term capital gains. In the case of equity mutual funds and stocks, STCG is charged at a flat rate of 20%. However, in the case of debt mutual funds, STCG is added to your overall income and taxed as per the tax slab you fall under.

Introduction to tax harvesting

Tax harvesting in mutual funds is a process wherein you sell a part of your mutual fund holdings and reinvest to keep the overall long-term capital gains below ₹1.25 lakh so that you do not pay any taxes. In other words, in tax harvesting, you do not allow the overall gains to cross ₹1.25 lakh.

What Is the ₹1.25 Lakh LTCG Exemption Limit and How Does It Work?

Under the prevailing tax system, the tax on long-term capital gains from shares and equity-oriented mutual funds is tax-free up to ₹1.25 lakh in a financial year. Only the amount exceeding this amount is subject to a tax rate of 12.5%.

Tax harvesting involves deliberately selling part of your investment to realise profit below ₹1.25 lakh in a financial year. Gains below this level are tax-free. However, if you do not do this and allow your gains to rise above ₹1.25 lakh, it will be added to your income and taxed according to your income tax slab rate.

How does tax harvesting work?

To utilise tax harvesting, you need to closely monitor the performance of your equity mutual fund or stock. While initially, the overall gains may not cross ₹1.25 lakh, your gains build over time. When you feel they will cross ₹1.25 lakh, you book profits, reinvest, and keep the gains below ₹25 lakh.

What Is the ₹1.25 Lakh LTCG Exemption Limit and How Does It Work?

Under the prevailing tax system, the tax on long-term capital gains from shares and equity-oriented mutual funds is tax-free up to ₹1.25 lakh in a financial year. Only the amount exceeding this amount is subject to a tax rate of 12.5%.

Tax harvesting involves deliberately selling part of your investment to realise profit below ₹1.25 lakh in a financial year. Gains below this level are tax-free. However, if you do not do this and allow your gains to rise above ₹1.25 lakh, it will be added to your income and taxed according to your income tax slab rate.

How Does Tax Harvesting Work?

To utilise tax harvesting, you need to closely monitor the performance of your equity mutual fund or stock. While initially, the overall gains may not cross ₹1.25 lakh, your gains build over time. When you feel they will cross ₹1.25 lakh, you book profits, reinvest, and keep the gains below ₹1.25 lakh.

When Should You Book Profits for Tax Harvesting?

Towards the end of the year is generally a good time to review your portfolio. It gives you a better idea of your total gains. But make sure you've held on to your shares for at least a year, making the gains long-term and not subject to short-term capital gains.

But know that you can harvest tax at any point in the financial year as long as you have not crossed the limit of ₹1.25 lakh and the gains have qualified as long-term capital gains.

How Can You Use Tax Harvesting?

Let us understand how you can use tax harvesting with an example. Suppose you invested ₹5 lakh in an equity mutual fund on 10th July 2024. After a year, the investment swells to ₹5.9 lakhs. If you redeem, your gains are ₹90,000, and your LTCG tax liability is zero. Upon redeeming, you invest this entire ₹5.9 lakh on 20th July 2025.

After a year, the investment value increases to ₹6.5 lakhs. Your gains in this case are ₹60,000 and under ₹1.25 lakh. If you had not redeemed, your gains would have been ₹1.5 lakhs (₹6.5 lakhs - ₹5 lakhs), and you would have needed to pay a 12.5% LTCG tax on ₹25,000. Along with tax harvesting, you can also use tax loss harvesting to lower your tax liability.

Tax Harvesting in Mutual Funds vs. Stocks – Is There a Difference?

Tax harvesting can be carried out for both mutual fund investments and shares because both types of investments fall in the same tax bracket for long-term capital gains. In the case of mutual fund investments, tax harvesting can be carried out relatively easily because you can redeem a certain amount and reinvest it at any point without any complexity, even in the same mutual fund scheme.

Whereas in stocks, you need to sell shares to realise gains and decide whether to buy back the same stock or reinvest the funds elsewhere. Market timing, liquidity, and transaction costs may play a slightly bigger role here compared to mutual funds.

Tax harvesting benefits

Here are some benefits offered by tax harvesting:

• Reduction in tax liability
  

Prudent tax harvesting allows you to lower your tax liability significantly. The reduction is more pronounced when you have an extensive equity portfolio of mutual funds that show incremental gains.

• Portfolio rebalancing
  

Tax harvesting not only allows you to lower your tax liability but also rebalance your portfolio. If your fund is not performing well for a long period, it allows you to sell it and reinvest the proceeds in a better-performing fund.

• Manage capital gains
  

You can manage your capital gains effectively through tax harvesting. Through it, you can spread out the gains over time rather than concentrate them in a single year, which could push you into a higher tax bracket.

• Helps in effective financial planning
  

Prudent tax harvesting can help you achieve a more tax-efficient investment strategy. It can help with effective financial planning, aligning with broader goals.

How Does Tax Harvesting Improve Post-tax Returns Over Time?

Taxes take away a portion of your earnings. So if you can harvest returns in time, you retain more capital within the investment portfolio. And any small amount you retain can compound significantly in the long run. Meanwhile, the harvested amount that you add back to your portfolio increases the base value of your investment, potentially lowering taxable gains for the subsequent years.

Conclusion

Tax harvesting can help you optimise returns by lowering your tax liability and potentially increasing your after-tax returns. You can reinvest the money saved through taxes in other asset classes according to your financial goals and risk tolerance.