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 MF 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 profits. 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).

Source: Live Mint

• 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.

Source: Live Mint and Cleartax

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.

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.

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 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 efficient tax efficient investment strategy. It can help with effective financial planning aligning with broader goals.

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.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.