Introduction
Paying taxes is the last thing on your mind when you invest, but it is a significant aspect that influences your investment returns. If you want to save on taxes, you can try tax harvesting. Also known as tax-loss harvesting, this strategy involves selling assets that have declined in value to offset the capital gains from other profitable investments. It is a widely used method to reduce tax liability and boost net returns from investments. Read along to learn if tax harvesting is a good strategy to adopt as an investor in stock and mutual funds.
How tax harvesting works
Tax harvesting is applied to mutual funds and other eligible investments in the following ways:
· Offsetting capital gains
If you have invested in mutual funds and stocks, you are liable to pay a long-term capital gains tax of 12.5% on gains exceeding ₹1.25 lakh in a year. If your gains qualify as short-term capital gains, you incur a tax of 20%. However, STCG is added to your overall income and taxed as per your tax slab in case of debt funds.
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Considering this taxation method, offsetting capital gains refers to balancing your losses against gains to reduce tax liability. For example, when you realise capital gains on the sale of a stock, you can sell another investment at a loss. This offsets your gains and reduces tax liability on them.
· Reducing taxable gain
Since LTCG applies to capital gains above ₹1.25 lakhs, you can save on the tax by reducing the gains. You can keep an eye on your gains and sell the investment before the gains exceed ₹1.25 lakhs. It is one of the ways to reduce your taxable income. But you still have to hold the gains for more than 12 months for this strategy to work against the LTCG tax. Otherwise, the gains will fall under the STCG category. Also, you would have to alert and track your fund's or security's performance.
Benefits of tax harvesting
Implementing the tax loss harvesting strategy involves the following benefits:
· Minimise tax liability
The main benefit of tax harvesting is reduced tax liability, especially if you have a large portfolio. Instead of paying taxes on profits, you can neutralise those gains with losses from other investments.
· Optimise portfolio performance
With tax harvesting, you can rebalance your portfolio. You can sell underperforming assets and reinvest the capital into better-performing investments. This helps with proper asset allocation.
· Increase long-term gains
By regularly implementing tax harvesting, you can protect a larger portion of your portfolio from taxation. As a result, you allow more returns to compound over time and increase long-term gains.
· Carry forward losses
The excess losses that you cannot use in the current financial year can be carried forward. This allows you to offset future gains with past losses for up to 8 years, providing long-term tax efficiency.
· Offset different kinds of gains.
You can apply tax harvesting to both short-term and long-term capital gains, making it flexible. It also works across different types of investments, including stocks, bonds, and mutual funds.
Is tax harvesting always a good strategy: Important considerations
All in all, tax loss harvesting is a good strategy but, its application and effectiveness depend on these considerations:
· Timing risk
Selling investments prematurely to harvest a loss can result in missed opportunities. For example, it can recover soon and may lose out on future gains. Hence, you should consider the timing and make the move consciously.
· Wash-sale rules
The wash-sale rules prevent you from repurchasing the same or similar assets within a specified period (typically 30 days) after selling them for a loss. Check such rules before tax harvesting.
· Transaction costs
Frequent buying or selling of investments for tax harvesting may lead to higher transaction costs. This can counter-serve your tax savings. You should consider the exit loads and penalties to stay prepared.
· Opportunity cost
Tax harvesting can potentially hinder your long-term growth strategies. Selling an asset purely to offset gains can lead to exiting from promising stocks. It is better to take this into account.
· Management complexity
When you implement a tax harvesting strategy on a portfolio of a diverse set of assets, management can get tricky. You want to have it streamlined and do a cost-benefit analysis with your financial advisor.
Conclusion
Tax harvesting is a valuable tool to optimise your investment returns by lowering your liability on capital gains tax. However, the decision to use this strategy should be well-thought-out. Consider your overall financial strategy, market conditions, and long-term goals. If you are a high-net-worth individual, tax harvesting can especially benefit you with high-tax savings. As a smaller investor, you can manage tax on your diversified portfolios with this tax-saving method. Make sure to weigh the risks and associated costs to make the most of it.
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