Mastering the trick of tax harvesting through normal portfolio rebalancing can help investors manage taxable returns more efficiently and can even be beneficial in keeping a considerable loss at bay.
Tax loss harvesting
Profit is appreciated by all and sundry but the idea of dealing with a loss is never encouraged with a welcome note. Yet ironically the concept of tax harvesting dwells on the idea of making a strategic use of loss or profit for greater gains.
At the end of every financial year we assess our portfolios to chalk out how much we have gained or lost over what we have invested on-both the large and the small cap dedicated funds. The previous year might have gifted you with stout returns on the large cap dedicated funds and have kept impoverished the small cap dedicated funds. Assessing gain and loss is not a big deal. The trick lies in mastering the skill of rebalancing the portfolio for the coming year. Sometimes the act of rebalancing the investment portfolio may bring profit (on selling large cap funds and buying a few small cap funds) or may incur loss (on selling small cap funds at rates lower than that in which they were purchased.) However, such a loss may not turn out to be that disheartening as it can benefit the investor with lucrative tax offsets or rebates ensuring greater gains. This is exactly where tax loss harvesting works.
Selling securities like mutual funds, equities and else at rates lower than that in which they were purchased can help the investors enjoy tax offsets on other capital gains.
The usual steps that “tax loss harvesting” cover:
- Identifying investments that are more prone to drain out wealth instead of encouraging an inflow of wealth and determining whether they are needed anymore or not. Assessing their worth the investor is to sell the underperforming ones and book the loss.
- Utilising the loss incurred, in a positive way in form of rebates on other taxable capital gains.
- Making use of the wealth gained by selling funds on new investments or securities that cater to one’s investment needs and asset allocation strategy.
Say, for a given financial year,
Short term capital gain (STCG) = Rs 2 Lakhs
Short term capital loss is Rs 1 Lakh.
If you discard taking advantage of tax loss harvesting,
Your amount of tax to be paid = Rs 2 Lakhs *15% (STCG tax rate) = Rs 30,000
On taking the advantage of tax loss of Rs 1 Lakh, the net amount of tax payable on your part would be,
Rs (2 Lakhs-1 Lakh)* 15%= Rs 15,000/-
Note that your tax liability gets mitigated by 50% once you take advantage of Tax loss harvesting.
Tax Gain Harvesting:
While tax loss harvesting has gained popularity all across the globe and is being practiced by smart investors, advantages of “tax gain harvesting” can also be enjoyed. The budget of 2018 has reintroduced after a long span of fourteen years tax on long term capital gains (LTCG) earned from company stocks and equity mutual funds or shares without any tax indexation benefits. Cost inflation index unlike before would not have any impact on such long term capital gains but an exemption of 1 lakh has been deemed acceptable. Thus only on profits more than 1 lakh, a tax rate of 10% would be imposed.
Investors, particularly the retail ones might have enjoyed tax exemption benefits on capital gains for perhaps two reasons. Firstly because some have started investing too late, in the last year only and are yet to be taken into consideration and secondly because in case of LTCGs January 3, 2018 has been grandfathered which implies that LTCGs made up till 31st January 2018 would enjoy exemption of tax. Gains made prior to it would be subject to income tax.
However, many smart investors perhaps have shifted their portfolios towards large cap dedicated funds way back, thereby making huge capital gains. What would they do? The smartest act on their part would be booking the profits and making fresh investments further on other securities which would serve their investment goals. This action would benefit them undoubtedly.
The fruits of such an action can be conceived if we consider three cases.
No tax gain harvesting: Pay tax when you sell your units
Let it be assumed in the first case that you would not be inclined towards taking pains in identifying, buying and selling MF schemes and SIPs until and unless there is a dire need on your part.
The following table charts the amount of tax that is to be paid on different SIPs in five years, if you keep investing for five years at a stretch and sell thereafter.
Note: Cells in green represent a situation where you need to pay tax if you book profit.
Assessment of tax with reference to the above table:
It has been assumed that you investment grows at a rate of 12% every annum.
Thus, if the investment is Rs 5,000 every month, at the end of a year it would be,
Rs 5,000*12= 60,000
Investment for 5 years would be,
Rs 60,000*5= 3,00,000
With the completion of 1 year as you sell your entire investment against a gain of Rs 105,518, your tax would amount to Rs 551.81
Note the exemption of Rs 1 Lakh,
Rs (105.518.06-100,000= 5518 @ 10% =551.5)
For investment amounting Rs 50,000 per month, in the second year itself the investment would exceed Rs 1 Lakhs. Yet you decide to sell it off at the end of the fifth year after bagging a gain of Rs 10, 55,180.
In such a case in accordance with the tax assessment calculation explained above, your net tax to be paid would be, Rs 95,518.06
Limited tax gain harvesting: Selling units when capital gain exceeds 1 Lakh
Under this case we consider booking of profit only if the amount exceeds 1 Lakh. Thus, if it is explained in the context of the above chart, from the very first year of investment on SIPs (meant to be invested for tenure of 5 years) you may generate profits, but no profit would be booked until the end of the fifth year when you sell all your units. Tax would be levied at that time on the overall gain that has been realised after five years.
Profit is to be booked as soon as the net profit exceeds the bar of 1 Lakh.
With reference to the table given for case I you can see that with an investment of SIP, Rs 50,000, you returns exceed Rs 1 Lakh in the second year itself.
You can reset your portfolio in the second year itself with a gain of Rs 153,248.
Selling your entire portfolio would go hand in hand with new purchase of the same units.
Give explanation and table
Booking profits and resetting portfolios this way will benefit you with a higher cost of acquisition.
Likely, with SIP of Rs 30,000 per month, portfolio reset will follow in the third year.
As you continue with this strategy, for SIP of Rs 50,000, your tax liability will be reduced by Rs 30,704 over a span of 5 years.
The table given below illustrates how the process works out and the amount of tax payable in five years.
The tax difference between the two cases – I and II is shown below:
Thus you can find out how by following this agenda you can save tax upto 1% of your total investment in five years.
Full tax gain harvesting: booking profit at the end of each financial year and resetting portfolio without taking into consideration the net amount of capital gain.
This is perhaps the most effective tax harvesting strategy where you reset your portfolio by selling units at the end of every year and further reinvest in them without bothering much whether the capital gain exceeds 1 Lakh or not. This strategy by far is proved to fetch you the best post tax returns. It aids in gaining capital gain exemptions every year. Such exemptions lapse at the end of every year instead of being carried forward. Thus it is better to avail such tax set-offs at the end of the year itself.
The following table illustrates how such gains work out.
The gain in the above table varies from that given in the previous one, every year ,except for the one belonging to the first year because, last year’s sales price gets treated as the purchase price in the current year, leading to a lesser gain every year when compared to the earlier two illustrated cases. This results in lowering the amount of tax payable in this case.
The above table illustrates the tax that is to be paid, over a span of five years following the other strategy as explained.
The practical: Do it yourself
The third case apparently although seems to be promising for the maximum tax benefits that it can fetch for the investor, implementing it on practical grounds tends to be a little bit arduous. This is particularly because the investment is made through SIPs and the investor has to bear the responsibility of keeping a track of the NAV’s movement at which the monthly investment is made. Even if the investor wants to sell some units of the MF equity fund as per personal choice, he would be stalled till the tenure of one year is completed for the sake of gaining LTCG tax exemption.
For MF investments the redemption of units is based on FIFO (First in First out basis.) Thus units purchased first will be redeemed first and the appropriate amount of tax on any long or short term capital gains is to be paid. For instance, if any of your SIPs has run for a span of one year from January to December, and some units are sold at a given time, on the capital gains per units, you will be taxed on the January units first and the December units, at the end.
Take for instance; you have invested on a fund at NAV Rs 10/- for the month of January and Rs 12/- for the month of February respectively and alike for the whole financial year. In the next year, as you will go to sell you MF for the month of January and will calculate the tax payable on your part the NAV of January and the MF units purchased during the same period would be considered first. In such a case therefore, it is mandatory to keep a track of the accurate cost basis data of all the MF units you purchased. A bit tedious though, the tax exemption definitely makes such an effort worthwhile.
The third case can be best illustrated if we take into consideration a multi-cap fund that has been in operation since 2008 and has remained unaffected by recent investment patterns and considerations.
Take for instance the NAV of January 10.
Assume that your SIP date is the beginning if the month and you have secured ‘X’ units against the purchase of the NAV prevailing on January 1st, 2010. You need to sell the unit belonging to January the next year and repurchase it the very next day without disrupting your normal SIP. This will help you to enjoy tax set off on STCG. Similar strategy is to followed even for the month of February (this year’s purchased unit for the month of February is to be sold next year in the same month itself). This agenda would continue until you decide to stop investing further.
This strategy has been followed by us for the next eight years that is till the end of 2018.
If the actual investment is 10.80 Lakh assuming a SIP of Rs 10,000, the fund value post 9 years after booking profit for each year would be Rs 21.18 Lakh, after the deduction of LTCG tax ( A couple of years with negative returns and therefore no profits falls in between).
Your investment would have valued Rs 20.66Lakh at the end of 2018, if you have invested without booking profits each year and after paying tax on the gain against such an investment, you would have retained Rs 19.77 in hand.
Therefore, the net profit you gain on your investment of Rs 10.8 Lakhs in 9 years would be Rs 1.4 Lakhs ( nearly 13% of your investment value.) The benefit of almost 1% of post ttax returns is noted when compared to the usual buying, holding and selling strategies.
Steps involved in tax gain harvesting:
- Identifying MF units that have completed the tenure of one year and are about to breed profit.
- Booking profit in fund and repurchasing it again.
- Taking advantage of the 1 Lakh tax exemption on LTCG and making use of the profit towards it.
- Purchasing different funds as sale proceeds.
Capital assets, STCG tax, LTCG tax and set-off rules:
Capital assets can be broadly divided into two types, – the short term and the long term. The short term capital assets are those that are held for a period of less than 36 months. However, in case of equity mutual funds the tenure of 36 months gets replaced by 12 months. Thus if an equity MF is kept for more than 12 months it would be treated as a long term capital asset. Debts, until and unless held for more than three years would be hailed as short term capital assets.
Gains or profits derived out of the sale of capital assets are subject to income tax under the head ‘capital gains.’
Short term capital gains:
Profits or capital gains received against the sale of short term capital assets.
Long term capital gains:
Profits gained through the transfer of long term capital assets.
While long term capital loss can be set-off against long term capital gains, short term capital loss can be set-off against both short and long term capital gains. If you fail to materialise tax set-off against your entire capital loss in the same year, both short and long term losses can be carried forward for eight assessment years immediately following the assessment year in which the capital loss got computed or recorded for the first time.
Tax harvesting has definitely proved to be promising in optimizing post tax returns. However the positive impact of tax harvesting on investment returns or capital gains cannot be always pinned down precisely or in exact percentage because the process is a bit complex one and it must be tracked in accordance with the NAV movement of fund. No matter what, our analysis proves without doubts that optimum post tax return benefits can be materialised through tax harvesting, particularly when both tax loss and tax gain harvesting is practiced cleverly. The results have been noted to be far more superior than what is received through common buying, holding and selling strategies.
Tax harvesting, must cater to your overall financial planning and investment goals. With the number of SIPs under you increasing, particularly when it goes beyond five, the task of keeping a track of investments and returns turns out to be tedious and cumbersome. Having performed the normal portfolio rebalancing act from time to time you can better manage your returns and investments and that too in a tax efficient manner.