What is tax loss harvesting?

Finding ways to reduce your tax load is on everybody’s scheme of things. Check out how investors can reduce their tax liabilities by harvesting loss.

What is tax loss harvesting?

Tax-loss harvesting is a process that many investors carry out at the end of each financial year. It’s a way to reduce the tax load and structure their portfolios to be better prepared for the upcoming year. The process requires investors to sell off mutual funds, stocks, and other securities that are worth less than what they paid to acquire them.

Let us find out how it works and how you can use it as a measure to save tax. 

How tax-loss harvesting works

As per the Union budget of 2018-19, all Long Term Capital Gains (LTCG) over Rs 1,00,000 are taxed at 10%, and all Short Term Capital Gains (STCG) are taxed at 15%. Before the budget of 2018-19, no capital gains tax was applicable to investments held for more than a year. In the process of tax-loss harvesting, investors sell their stocks and other holdings at a loss to reduce their capital gains tax burden. 

Related: Slash down your tax liability with NPS and Health plan

Here’s how it works: 

1. Understand your incomes: The government classifies a taxpayer’s income under five different categories: income from salary, income from house property, income from a business, income from other sources, and capital gains. It is important to understand your tax liabilities from all of these categories in order to understand your overall tax due for the given financial year.

2. Analyse your portfolio: As an investor, it is important for you to review your portfolio to check which of your investments have been making losses or performing below par. Not all of your securities will fall under the realm of capital gains; some may also fall under speculative or non-speculative business income.

3. Sell off the stragglers: After having picked out the investments that qualify for capital gains, you need to check which ones are running at a loss or bringing inadequate returns. The investments that are beyond the scope of revival should be flagged as ‘equities that need to be sold’.

4. Reduce your tax load: Selling off underperforming equities, often even at a loss, reduces an investor’s capital gains for a specific financial year. This further reduces the tax liability.  For example, consider a scenario where you have two stocks. Stock A has been underperforming and stock B has been performing splendidly. Now when you sell stock A at a loss and stock B at a profit, you can use the loss to offset the profits. This will reduce your overall tax liability.

5. Reuse the money: Naturally, selling a security at a loss does not sound like a lucrative deal. This is why it is important to effectively use the money that you earn from selling the stocks to buy new and more profitable stocks. 

6. Balance your portfolio: While tax loss harvesting is based on the concept of saving tax, the more important goal for an investor is always to earn high returns for the money invested. It is, therefore, important to ensure a balanced asset allocation in your portfolio while replacing old stocks with new ones. Do not lose sight of the bigger picture. 

7. Diversify: Along with asset allocation, another important component that tax-loss harvesting aligns with is diversification. Selling off old equities for new ones is a great way to diversify your portfolio.

You should bear in mind that tax-loss harvesting is not a way to completely evade losses; it only safeguards you from paying heavy taxes.

Related: Here's how you can file tax returns on your capital gains

When is the right time for tax-loss harvesting?

Though most investors carry out tax-loss harvesting at the end of the year, there is no specified time. You can sell your non-performing stocks at any time of the year. But the right time to consider tax-loss harvesting is when the holding period of the equity has crossed the one-year mark. An investment that is less than 12 months old does not qualify for LTCG. If you sell your stocks or equity mutual funds within 12 months, your gains will qualify for STCG tax of 15%. In the same, for any stocks or equity funds that you sell after a period of 12 months, you qualify for LTCG tax of 10% on the gain above Rs. 1 lakh.

In the case of short term capital loss, you can carry forward the loss for the next 8 years and adjust it against short term or long term capital gains made over these 8 years. Similarly, a long term capital loss can be taken forward for a period of 8 years and can be adjusted against long term capital gains over these 8 years.

In case of mutual funds, you should also be wary of the exit penalties applicable to your funds if they are withdrawn before a period of 12 months. 

Related: How is dividend income taxed?

What are the important points to consider during tax-loss harvesting?

Tax-loss harvesting can be effectively used to enjoy LTCG tax exemption on amounts up to Rs 1,00,000. But there are some key points that investors should remember:

1. Understand your tax liability: Investors must understand their incomes and liabilities from all probable sources of tax. They should be able to differentiate between their income from capital gains and their income from a business. It is only when one has a sound understanding of their taxes that they can determine the best way to implement tax-loss harvesting.

2. Don’t think of it as an investment: Tax-loss harvesting is merely a way to reduce the tax liability. It is not a method or type of investment that should be seen as a way to maximise one’s returns.

3. Choose replacements wisely: While selling off old equities and replacing them with new ones, one should carefully analyse the loss or risk factors of the new investment. 

To sum up

Tax-loss harvesting works in sync with other aspects of investing, such as diversification, risk, asset allocation, etc. So, it is important to have a deep understanding of your taxes and income before you begin the process. One should not just focus on the current financial year, but also on the forthcoming years and the loss harvested from previous years. Investors should also be mindful of the exit penalties that come with various funds. 

Want to know more about capital gains? Here’s a simplified guide.

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