Tax Loss Harvesting: A Guide to Reducing Your Taxes Through Smart Planning

When you invest in equity funds, the returns you earn may be subject to capital gains tax, depending on how long you hold the investment. One effective way to reduce this tax burden is through tax loss harvesting. This strategy involves offsetting your investment gains with losses, helping to lower your taxable income and maximise wealth over time. While this approach may seem indirect, it can be an effective tool for anyone aiming to grow their portfolio.

What is tax harvesting’s meaning?

Tax harvesting in mutual funds is a strategy that involves selling investments that have suffered a loss to offset capital gains from other investments. The goal is to minimise your tax liability by balancing the gains you made with the losses you've incurred. This approach effectively reduces both short-term and long-term capital gains taxes.

How does tax loss harvest work?

Let’s say you’ve invested in Stock A and Stock B.

Stock A has performed well, giving you a short-term capital gain of Rs 50,000. However, Stock B has underperformed, resulting in a loss of Rs 30,000.

Here’s how the taxation would look-

Without tax loss harvesting

The short-term capital gain from Stock A is Rs 50,000.

With the STCG tax on equity funds at 20%, your tax liability would be Rs 10,000 (Rs 50,000 * 20%).

With tax loss harvesting

The short-term capital gain from Stock A is Rs 50,000, and the loss from Stock B is Rs 30,000. This results in a net gain of Rs 20,000.

Now, the tax will be applicable on the net gain of Rs 20,000, resulting in a tax of Rs 4,000.

By applying the tax loss harvesting strategy, you have reduced your tax liability from Rs 10,000 to Rs 4,000, saving Rs 6,000.

Things to keep in mind while tax loss harvesting

While tax loss harvesting sounds like a great way to save money, there are a few factors to keep in mind-

1. Wash sale rule

A wash sale occurs when you sell underperforming assets and repurchase the same investment within 30 days before or after the sale. In this case, you cannot claim the loss for tax purposes. This rule prevents investors from artificially creating losses for tax benefits.

2. Applicability

Long-term capital losses can be used only to offset long-term capital gains, whereas short-term capital losses can offset both long-term and short-term capital gains.

3. Expert advice

It’s always wise to consult a tax advisor or financial planner before executing tax loss harvesting, as the rules can be complex. They can help you better understand this strategy.

Wrapping up

Tax loss harvesting is a powerful strategy that reduces your tax liability and helps your investments grow. By offsetting your capital gains with losses, you keep more of your wealth and improve your financial position.