Tax Loss Harvesting – What is it & How does it Work in improving Returns
Optimising your capital gain taxes
Many investors prefer to either nullify or minimise their capital gains tax. One of the ways of doing it is through the process of tax harvesting. This article focuses on what tax loss harvesting is and how it works to improve your returns.
Capital gains in mutual funds
Before we discuss tax harvesting, it is important to understand the concept of capital gains. When you sell your mutual fund units at a higher price than you bought them for, the profit is known as a capital gain. Similarly, when you sell your mutual fund units at a lower price than you bought them for, the loss is known as a capital loss.
- Short-term capital gain: When you sell your equity mutual fund units within 12 months of purchase, the short-term capital gain is taxed at 15%.
- Long-term capital gain: When you sell your equity mutual fund units after 12 months of purchase, the long-term capital gain is taxed at 10% without indexation after exempting the first Rs. 1 lakh.
What is tax harvesting?
Tax harvesting is the process of selling a part or all of your mutual fund units and using the capital loss to offset your capital gain or using the capital gain to nullify or minimise your overall capital gains tax. Now that we understand the tax harvesting meaning let us understand how it works.
Tax harvesting in mutual funds
Let us take a couple of examples to understand how tax harvesting works.
Example 1: Nullifying or minimising long-term capital gain tax
Jaya has invested Rs. 5 lakhs in a mutual fund scheme. After one year, the value of her investment is Rs. 5.8 lakhs. Jaya redeemed her entire investment and booked a long-term capital gain of Rs. 80,000. As the first Rs. 1 lakh long-term capital gain is exempt from taxation, Jaya will not have to pay any tax.
Jaya decides to reinvest the entire amount of Rs. 5.8 lakhs again in the same mutual fund scheme. So, now Jaya’s investment value has been reset to Rs. 5.8 lakhs. Thus, Jaya could nullify her long-term capital gains tax with the help of tax harvesting, reinvest the entire amount again, and continue with her investment journey.
Example 2: Using tax harvesting to offset the capital loss with capital gain
Karan has invested Rs. 3 lakhs in Mutual Fund Scheme A and Rs. 3 lakhs in Mutual Fund Scheme B more than a year back. The current value of Mutual Fund Scheme A is Rs. 2 lakhs, and of Mutual Fund Scheme B is Rs. 5 lakhs.
Karan is sitting on a long-term capital loss of Rs. 1 lakh on Mutual Fund Scheme A and a long-term capital gain of Rs. 2 lakhs on Mutual Fund Scheme B. Karan can redeem all the units of both the schemes. From the Rs. 2 lakhs long-term capital gains on Scheme B, the first Rs. 1 lakhs long-term capital gains tax will be exempt. He will have to pay 10% long-term capital gains tax on the remaining Rs. 1 lakh.
However, Karan can offset the Scheme B Rs. 1 lakh long-term capital gains against the Scheme A Rs. 1 lakh long-term capital loss. So, in this case, Karan will not have to pay any long-term capital gains tax due to tax loss harvesting.
Karan can reinvest all the redemption money again either in the same mutual fund schemes or other mutual fund schemes. When he reinvests, the value of his investments will be reset to the current value. So, Karan could nullify his long-term capital gains tax with the help of tax-loss harvesting, reinvest the entire amount again, and continue with his investment journey.
Benefits of tax loss harvesting
The major benefits of tax loss harvesting include the following:
- You can offset your short-term capital loss with a short or long term capital gain. However, a long-term capital loss can be offset only with a long-term capital gain.
- When you reinvest the amount, the value of your investment is reset to the current value.
Things to keep in mind while tax harvesting
While using the tax harvesting strategy, it is important that an investor should reinvest the redeemed amount as soon as possible. If the investor doesn’t reinvest, the financial planning journey will get disrupted. Also, if there is a long time gap between redemption and reinvestment, the NAV may change significantly. If you hold on to your reinvestment and the market moves up significantly, you will miss the gains.
The financial year ends on 31st March. So, any tax harvesting that needs to be done has to be done with this date in mind. While you can do tax harvesting any time during the entire financial year, it has to be done before 31st March, or else the tax harvesting strategy will spill over to the next financial year.
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