While we all want to see our country grow and develop, one thing that bugs us is paying taxes. Nobody likes paying taxes, especially, considering the numerous heads under which we are liable to list our income sources and calculate our tax burden accordingly. Lately, there has been a clamour regarding taxes on long-term capital gains from mutual funds with many industry members seeking waiver of the same. To escape paying taxes, many investors resort to tax harvesting. However, not many are aware of this concept and strategy.
Understanding tax harvesting (tax-gain harvesting)
To understand what “tax harvesting” is and how it can be used to mitigate the resulting tax burden from long-term capital gains, it is important to understand what “long-term capital gains” are and how and when they are liable to be taxed.
To start with, any long-term gain from equity investments that exceeds Rs. 1 lakh in a fiscal year is taxable at 10 percent. Also, you label capital gains as long-term gains only when you earn returns after having held your equity investments for more than a year. Investors new to parking their money in mutual funds need not worry as it takes a while for yearly gains to cross the ₹1 lakh limit.
SIP fund investments
Let’s say that you are investing in mutual funds through regular systematic investment plans (SIPs). Assuming that you invest ₹10,000 every month in a mutual fund with an expected return rate of 12 percent per annum. This way, you would have earned estimated returns of ₹75,076 in three years. However, the returns would go up to ₹1,38,348 in four years, thus, subjecting to long-term capital gains tax. To escape this, you can redeem ₹75, 076 at the end of three years, and then reinvest the same amount in the fund. This way, you not only escape the tax before breaching the long-term capital gains limit but also add to your investment. Similarly, if you invest ₹15,000 every month, your capital gains would round up to an estimated figure of ₹1,12,615, thus, exceeding ₹100,000 in three years. This explains why you must resort to tax harvesting in two years in the latter instance.
Lump sum investments
In the first instance, you had reinvested the lump sum returns back into the fund, which means that you will have to take care of the returns earned on the new investment amount while also redeeming returns before they breach the ₹100,000 limit.
The “tax harvesting” method is applicable to lump sum investments too. So, if you had put in ₹100,000 lump sum to invest, you can resort to tax harvesting at the end of six years subject to 12 percent returns on the fund.
Understanding tax-loss harvesting
There is another concept called “tax-loss harvesting” in which you book losses to offset the capital gains from any other fund to lower your tax liability. For example, you invest ₹2 lakh in a fund but due to recurring volatility, your fund value comes down to ₹1,84,000 in two years. This way, you suffer a loss of ₹16,000. Now you can sell this investment though you must remember to reinvest the money in another fund immediately. You can use the losses booked to offset any long-term capital gains earned from any other fund during the year. Also, you can carry forward the losses for up to eight assessment years if you do not use your capital losses booked to reduce your capital gains during the year.
Many investors resort to tax-loss harvesting as an important tax-saving strategy. A good way to use tax-loss harvesting is to remove underperforming funds from the portfolio while remaining invested in good funds that may have experienced a minor blip in the short term.
Investors with a large equity portfolio also benefit from higher incremental gains. As a result, if you want to pay low or no taxes, you must ensure that your gains do not exceed the tax-free limit, which is the goal of “tax harvesting”. Simply said, in tax harvesting, you book profits in any mutual fund instrument to reduce your tax liability.
