Tax harvesting, also known as tax-gain harvesting is a strategy used to save taxes on long-term capital gains from listed stocks and equity mutual funds.
But first, let’s understand the taxation on these investments.
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If you sell listed shares or equity mutual funds within 12 months of holding them, any gains are considered short-term capital gains and taxed at a rate of 20%.
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On the other hand, if you hold these investments for more than 12 months, the gains qualify as long-term and are taxed at 12.5%. However, you get an exemption of ₹1.25 lakh and hence, the gains exceeding ₹1.25 lakh are taxable.
How does tax harvesting work?
Tax gain harvesting strategy leverages the ₹1.25 lakh exemption available for long-term capital gains from shares and equity mutual funds.
So basically, whenever your long-term capital gains for a financial year are about to exceed ₹1.25 lakh, simply book the profits and reinvest the entire amount.
Let’s take an example:
You had invested ₹8 lakh in a mutual fund. After 3 years, the value of your investment grew to say, ₹10 lakh, giving you unrealized gains of ₹2 lakh.
If you redeem all your units at once, your gains above ₹1.25 lakh would be taxable. Instead, you redeem only enough units to realize gains of ₹1.25 lakh. Since this is within the LTCG exemption limit, you don’t have to pay any tax.
Now, you reinvest that amount back.
By doing this, your taxable LTCG becomes zero, and you save ₹9,375 in taxes.
| Particulars | Amount |
|---|---|
| Investments | ₹8,00,000 |
| Market value after 3 years | ₹10,00,000 |
| Unrealized gains | ₹2,00,000 |
| Harvested Gains | ₹1,25,000 |
| LTCG exemption | ₹1,25,000 |
| Taxable LTCG | ₹0 |
| Tax Savings @12.5% | ₹9,375 |
This is because every time you reinvest, your purchase cost changes and so do your capital gains.
Does tax harvesting affect compounding?
Because you are selling your investment every year, a lot of people think that tax harvesting affects the compounding of their portfolio.
However, tax harvesting involves not only selling a part of your investments but also reinvesting the entire proceeds including the profits, and hence this doesn’t affect your compounding.