None of us enjoys paying taxes. Yet we need to pay tax on our income, GST on things we purchase, and since 2018 on the gains we make from our investments in Mutual Funds.
In this blog, we will tell how you can reduce and even make taxes on long term capital gains from mutual funds zero.
Tax Harvesting: What is it and how you use it?
To understand how you can use tax harvesting to reduce your long term capital gains, you first need to know how long term capital gains are taxed.
In 2018, the late Finance Minister Arun Jaitley re-introduced the long-term capital gains on equities. Now any long-term gain made from equity investments over and above Rs. 1 lakh in a financial year is taxable at 10%. And if you are wondering what long capital term gains are, well, it the returns you make by selling your equity investments held for more than 12 months.
Now if you are a new investor or beginning in mutual funds, your yearly gains may not cross the Rs. 1 lakh limit immediately. But, when you let your profits run over for a long time, it will cross the threshold at some point. For instance, if you invest Rs. 5,000 per month in equity funds, with 12% average annual returns, you will have taxable gains within 5 years. This period will be just 3 years if you invest Rs. 15,000 every month
Here, you can see the SIP amount and the capital gains with 12% annualized returns over different periods.
|Capital Gains at 12% Annualized Returns|
|SIP Amount||After 24 months||After 36 months||After 48 months||After 60 months|
Similarly, people who have a large equity portfolio will have higher incremental gains. Therefore, if you want to pay low or no taxes, you need to ensure these gains don’t build up beyond the tax-free limit, and that’s what Tax Harvesting is all about.
[bctt tweet=”Tax harvesting is the strategy of selling a part of your mutual fund units to book long term capital gains and reinvesting the proceeds in the same mutual fund.” username=”@ETMONEY”]
To understand this better, let’s take an example. Assume you have invested Rs. 5,00,000 in an Equity Mutual fund on 15th Jan 2020, and on Jan 19th, 2021, the value of this investment becomes Rs. 5,90,000. Now, if you redeem this, your gains will Rs. 90,000, and your tax liability will be zero. That’s because any Equity Investment held for more than 12 months qualify for Long Term Capital Gains, and the tax has to be paid only if gains exceed the limit of Rs.1 lakh in a financial year.
Next, you invest this entire amount, i.e., Rs. 5,90,000 soon after redeeming. Your investment cost will be reset to Rs. 5,90,000, along with the date of investment. Now, say your investment value increases to Rs. 6,50,000 after another year. When you redeem, your gains will be Rs. 60,000 – which is still less than the Rs. 1 lakh limit. Had you not redeemed and reinvested the amount, your long term gains would have been Rs. 1,50,000 (Rs.5,00,000-Rs. 6,50,000), and you would have needed to pay 10% tax on the amount that exceeded the limit of Rs. 1 lakh. So a tax of Rs. 5,000 (10% of 50,000).
You can use this method even when you are investing via SIPs. You can redeem units that you have held for more than 12 months and reinvest. However, if you redeem the units but don’t reinvest, the strategy becomes meaningless.
Tax Loss Harvesting: Another way to save tax
In tax-loss harvesting, you book losses and offset gains in any other instrument to bring down your tax liability.
Let’s say you have invested Rs. 2 lakh in a fund on 15th January 2020. And now, on January 22, your investment value is Rs. 1.84 lakhs. In this scenario, your long-term capital loss is Rs. 15,000.
Now, if you sell this investment, you are booking the losses (but do remember to reinvest this money immediately), and you can use this to offset any long-term capital gains you might have received in the year. If you cannot use your capital loss to reduce your capital gains in one year, you can carry forward the losses for up to 8 assessment years.
For example, 2 years down the line, you sell a long term equity MF investment and make Rs. 1.5 lakh in capital gains. Since you are Rs. 50,000 above the limit, you have to pay tax. However, you can remove this Rs. 15,000 from the Rs. 1.5 lakh gain for tax calculation. So your effective LTCG will be Rs 1.5 lakh – Rs. 15,000 = Rs. 1,35,000, and you will pay tax only on Rs. 35,000 as against Rs. 50,000 you would have paid otherwise.
This is how tax-loss harvesting acts as a critical strategy to save tax for many investors. A good way to use tax-loss harvesting is to remove underperforming funds from the portfolio and not exit from good funds that might have seen a small blip in the short term.
Tax gain and tax loss harvesting are simple yet effective ways to bring down the taxes you will pay on your equity investments. Remember, you have to reinvest the money as soon as you get the redemption amount in your account or run the risk of breaking your compounding journey.
For tax harvesting we have to reinvest the redeemed amount ASAP. What is the timeline for this ASAP? Can be a month?
Hi Pallab. It is better if you reinvest in 2-4 days rather than waiting for a month.
how can we get this tax harvesting benefit in case of ELSS funds
Dear Ajay, thank your for your query. ELSS tax saver mutual funds are Equity Mutual Funds that have a lock-in period of 3 years. So in order to apply tax harvesting, you will have to wait 3 years and then redeem your investments such that your returns in a financial year do not exceed the Rs. 1 lakh tax-free limit.
Whole doing this tax harvesting, my NAV growth wil be affected? I mean old NAV wil be sold out in FIFO basis. New purchase wil take again long time to reach a higher NAV. So pls tell me, tax harvesting affects my growth percentage?
The NAV has no relation what so ever with the growth of your investments. As long as you re-invest the money soon after the redemption amount hits your bank account, you will continue on your journey of growth.