What is Tax Harvesting for Mutual Fund Returns?

Tax harvesting is a smart way to reduce taxes on mutual fund investments. It works by selling underperforming mutual fund units to offset the gains made on other investments. This strategy helps us save on taxes while keeping our overall returns intact. This blog will break down what tax harvesting means, how it benefits mutual fund investors like us, and how to use it in a practical, easy-to-understand way.

Tax Harvesting Overview

Tax harvesting for mutual fund returns is a technique that helps reduce the amount of taxes we pay on investment gains. It works by selling investments that have lost value to offset the gains made on other profitable investments. 

When we make a profit from mutual funds, those gains are subject to capital gains tax. However, if we have other funds that haven’t performed well and are at a loss, we can sell them to “harvest” the loss. This loss then reduces the total taxable gains, meaning we pay less in taxes.

Short-Term vs. Long-Term Tax Harvesting

Short-term tax harvesting refers to selling investments that have decreased in value within one year of purchase. When you sell a security at a loss, you can use that loss to offset any short-term capital gains you have realised during the tax year. 

Long-term tax harvesting involves selling investments that you’ve held for more than one year. Losses from these sales can offset long-term capital gains. Long-term capital gains are generally taxed at a lower rate than ordinary income, making it beneficial to utilize losses to offset these gains.

Here is a comparison of both: 

Common Tax Harvesting Strategies in Mutual Funds

Tax harvesting can be done in different ways, helping us reduce the amount we pay in taxes. Here are some popular strategies we can use:

Selling Underperforming Mutual Funds

One of the easiest ways to apply tax harvesting is by selling mutual funds that have underperformed. By selling funds that show a loss, we can offset the gains made from other investments. This can help reduce our taxable income. Many investors use this method toward the end of the financial year to balance their gains and losses for tax purposes.

Switching Between Mutual Fund Schemes

Another smart approach is switching between mutual fund schemes within the same fund house. If we have a mutual fund with long-term losses, we can move our investment to another scheme. This helps us realise the losses for tax benefits while staying invested. It’s a way to manage taxes without pulling out of the market.

Using Wash Sales

A wash sale involves selling a mutual fund at a loss and then repurchasing it shortly after. This allows us to book the loss for tax purposes while maintaining our investment position. However, we need to be careful when using this strategy, as it may draw attention from tax authorities if not done properly.

Indian Tax Laws for Tax Harvesting

When it comes to tax harvesting, knowing the tax laws that apply to mutual funds in India is crucial. Here are a few important sections:

Section 112A

This section applies to Long-Term Capital Gains (LTCG). If our LTCG exceeds ₹1 lakh from the sale of listed equity shares or equity-oriented mutual funds, we are taxed at 10% without the benefit of indexation. This applies if we have held the fund for more than a year and if the Securities Transaction Tax (STT) was paid.

Section 111A

This section deals with Short-Term Capital Gains (STCG) on equity shares or equity-related instruments held for less than 12 months. If STT was paid during the transfer, these gains are taxed at 15%. For debt funds, the gains are now taxed based on the investor’s income tax slab rate, regardless of how long the funds were held.

Section 70 – Set-off of Losses

Under this section, short-term losses can be set off against both short-term and long-term gains, while long-term losses can only be offset against long-term gains. This is important for investors who want to manage both types of gains and losses effectively.

Section 73-74 – Carry Forward of Losses

These sections allow us to carry forward capital losses for up to eight years. This means if we cannot use the losses in the current financial year, we can apply them to gains in the future, maximising our tax benefits over time.

Also Read: Is Investing in SIP Tax-Free?

How to Apply Tax Harvesting in Mutual Funds?

Here’s a step-by-step guide to applying tax harvesting in mutual funds:

Step 1: Review the Portfolio for Losses

• Begin by examining the mutual fund portfolio to identify any funds that have decreased in value since their purchase. These are the funds to consider selling for tax harvesting purposes.
• Focus on funds that have underperformed over time and show little sign of recovery.

Step 2: Calculate Gains and Losses

• After identifying loss-making funds, calculate the total capital gains from profitable investments to estimate the potential tax liability.
• Next, the losses from the underperforming funds are calculated to determine how much of the gains can be offset.

Step 3: Sell Loss-Making Funds

• Once the losses are calculated, sell the underperforming mutual funds to realise the loss, which can then be used to offset capital gains.
• Ensure that the sale is completed within the same financial year to apply the losses to that year’s tax return.

Step 4: Offset Gains with Losses

• The losses from the sale can now be applied against the profits from other investments, effectively reducing taxable capital gains.
• This approach helps lower the tax burden, which can improve the overall return on investment.

Step 5: Reinvest the Proceeds

• After selling the loss-making funds, reinvest the proceeds into new mutual funds or other investments that align with long-term financial goals.
• This ensures that the portfolio remains balanced and continues to grow while benefiting from tax savings.

Conclusion

Tax harvesting is a valuable tool that helps us reduce our tax liability and maximise our mutual fund returns. By selling loss-making investments and offsetting them against gains, we can save money on taxes and keep our portfolio growing. The key is to use tax harvesting strategically without compromising on long-term investment goals. If done correctly, it can be a great way to boost overall returns.