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.
- 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 15%.
- On the other hand, if you hold these investments for more than 12 months, the gains qualify as long-term and are taxed at 10%. However, you get an exemption of ₹1 lakh and hence, the gains exceeding ₹1 lakh are taxable.
How does tax harvesting work?
Tax gain harvesting strategy leverages the ₹1 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 lakh, simply book the profits and reinvest the entire amount.
Let’s take an example:
You had invested ₹5 lakhs in a mutual fund in Jan 2020. After 12 months, the value of your investment grew to say, ₹5.60L.
If you redeem these units, your long-term gains for the year would be ₹60,000, on which you’d not have to pay any taxes.
Now, you reinvest the entire ₹5.60L.
Again, your gains of ₹90,000 would be exempted from taxes.
This is because every time you reinvest, your purchase cost changes and so do your capital gains.
If you did not harvest these gains, your profits after 2 years would have been calculated based on the original investment amount of ₹5 lakhs, resulting in taxable gains of ₹1.5 lakhs.
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.