Tax harvesting is a strategy used by investors to minimize their tax liabilities by offsetting gains with losses. When it comes to mutual fund investments, this approach can be particularly beneficial in 2024.
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By realising capital losses on underperforming mutual funds, investors can use those losses to offset the taxes owed on capital gains from their profitable funds. This way, tax harvesting allows investors to potentially reduce their overall tax burden and keep more of their investment returns.
In this blog post, we’ll explore tax harvesting and how it can be applied to mutual fund portfolios.
Understanding Tax Harvesting for Mutual Funds
Tax harvesting for mutual funds involves selling mutual funds at a loss to offset capital gains from other investments, thereby reducing the overall tax liability. This strategy takes advantage of specific tax provisions that permit the adjustment of losses against gains. Additionally, investors can employ a strategy of booking profits up to Rs. 1 lakh and buying back the same or similar investments. Since gains up to Rs. 1 lakh are exempt from taxes, this approach effectively makes profits tax-free, akin to the concept of wash sales.
Common Tax Harvesting Strategies in Mutual Funds
Selling Underperforming Mutual Funds
One such easy way to harvest tax is selling mutual funds that have underperformed. By realising these losses, investors can counterbalance gains from other investments which in turn reduces their taxable income. This practice is often carried out towards the end of the financial year to reduce losses for tax purposes.
Switching Between Mutual Fund Schemes
Another such method involves switching between mutual fund schemes within the same fund house. By moving from a scheme with long-term losses to another scheme, investors can realise these losses against other gains wherein the investor reduces his taxable income while also remaining invested.
Utilising Wash Sales
A wash sale entails selling a mutual fund at a loss and then repurchasing it shortly after. This allows investors to book losses for tax purposes while also maintaining their investment position. Although effective, this strategy must be used cautiously to avoid unwarranted inspection from the tax authorities.
Tax Laws Governing Harvesting in India
To implement tax harvesting within the legal framework, it’s essential to understand the relevant income tax rules in India:
Section 112A
Section 112A deals with Long-Term Capital Gains (LTCG). If the LTCG exceeds Rs. 1 lakh from the sale of listed equity shares, equity-oriented mutual funds, or units of a business trust, a 10% tax is applied without indexation benefits. This tax applies only if the Securities Transaction Tax (STT) was paid during both the transfer and acquisition in specific scenarios. Adding on this is only applicable if the equity shares or funds are sold after being held for longer than a year
Section 111A
Section 111A covers Short-Term Capital Gains (STCG). Gains from transferring equity shares and equity-related instruments held for 12 months or less fall under this section. If the Securities Transaction Tax (STT) was paid during the transfer, these gains are taxed at a flat rate of 15%. If STT was not paid, the gains are taxed according to the individual’s income tax slab rate.
For debt funds, this section is no longer applicable. Debt funds are now taxed at the individual’s income tax slab rates, regardless of the holding period. This means that gains from debt funds will be taxed based on the investor’s total income, rather than benefiting from a separate, potentially lower tax rate for short-term holdings.
Section 70 – Set off of Losses
Section 70 of the Income Tax Act, of 1961, allows for the set-off of losses from one source against income from another within the same head. This is crucial for tax planning and tax-loss harvesting strategies. Key points include:
- Short-term capital losses can be set off against both short-term and long-term capital gains.
- Long-term capital losses can only be set off against long-term capital gains.
- Certain losses, like speculation losses, can only be set off against specific types of income.
Section 73-74 – Loss Carry Forward Provisions
Sections 73-74 permit carrying forward capital losses for up to 8 assessment years to offset future capital gains. This extends the benefit period for tax advantages, allowing investors to utilise these losses against future gains.
Practical Application of Tax Harvesting
Investors should apply tax harvesting responsibly to avoid penalties. Here are some practical tips:
- Review Your Portfolio Regularly: Assess your mutual fund investments periodically to identify underperforming funds that could be sold for tax harvesting.
- Plan Ahead: Implement tax harvesting strategies towards the end of the financial year to maximise benefits.
- Understand the Rules: Familiarise yourself with the relevant tax laws to ensure compliance and avoid potential pitfalls.
- Consult a Financial Advisor: Professional advice can help tailor tax harvesting strategies to your specific financial situation and goals.
Conclusion
Tax harvesting is a valuable tool for managing tax liabilities within a mutual fund portfolio. By understanding and applying the relevant tax provisions, investors can strategically manage their investments to optimise their tax outcomes. As with any financial strategy, it is crucial to execute tax harvesting responsibly and in compliance with the law to reap the full benefits without facing penalties.
