Tax harvesting is the practice of selling and repurchasing stocks and equity mutual funds to take advantage of applicable tax laws and there by save tax on stocks and mutual fund returns.
Did you know that you can pay lower than 12.5% tax on long term capital gains on mutual funds and equity returns. In fact, in some cases, it may be possible to pay almost zero taxes on your mutual fund returns.
Capital Gains Tax on Stocks and Equity Mutual Funds
As per existing Income Tax laws in 2024, long term capital gains in stocks and equity mutual fund returns are taxed at 12.5%. However, as per Section 112A, there is an exemption of INR 1.25 Lakhs on Security Transaction Tax paid assets, which includes stocks and equity oriented mutual funds. If you use the section 112A provision smartly, you can save a significant portion of taxes on equity mutual funds and stocks.
Mutual Fund Capital Gains Tax without Tax harvesting
Say, you invested a lumpsum of INR 10,00,000 in an equity oriented mutual fund in 2020. You plan to sell the proceeds in 2030 for your son’s higher education. And the expected rate of return is a conservative 10% per year.
| Year | Fund Value |
|---|---|
| 2020 | 1000000 |
| 2021 | 1100000 |
| 2022 | 1210000 |
| 2023 | 1331000 |
| 2024 | 1464100 |
| 2025 | 1610510 |
| 2026 | 1771561 |
| 2027 | 1948717 |
| 2028 | 2143588 |
| 2029 | 2357947 |
| 2030 | 2593742 |
Normally, based on the 10% rate of return, the INR 10,00,000 would have grown to INR 25,93,742. Hence, the profit in 2030 is INR 25,93,742 – INR 10,00,000 = INR 15,93,742. And applying section 112A, the taxable income is INR 14,68,742 (15,93,742 – 1,25,000), which is taxed at 12.5%.
So, the net capital gains tax payable is INR 1,83,592. Net proceeds available at the end of 10 years is INR 25,93,742 – tax INR 1,83,592 = INR 24,10,150.
| Cost of Investment in 2020 | INR 10,00,000 |
| Value of Investment in 2030 | INR 25,93,742 |
| Capital Gain in 2030 | INR 15,93,742 |
| Capital Gains Tax = 12.5% of (INR 15,93,742 – INR 1,25,000) | INR 1,83,592 |
| Value of Investment after Tax | INR 24,10,150 |
But, what if you can reduce this tax rate of 13%. And you can do this by smartly utilizing the same section 112A.
Mutual Fund Capital Gains Tax with Tax harvesting
Now lets see how tax harvesting can save tax on mutual fund returns.
Say, again you invest a lumpsum of INR 10,00,000 in the same equity mutual fund in 2020. And the goal is to have the proceeds ready in 2030 for your son’s higher education at the same 10% expected rate of return.
But this time, you follow a different approach and the magic word is ‘tax harvesting‘. A equity mutual fund held for 12 months or more is considered long term and any gain is taxed at long term capital gains rates. So, at the end of every 12 months (on day 366), you sell all the units in your account and repurchase back immediately. Thereby you realize the capital gain every year and pay necessary tax on the gains every year.
Consider year 1, you invested lumpsum of INR 10,00,000, which grew 10% to INR 11,00,000 by end of the year. On day 1 of year 2, you sell all the units and realize of profit of INR 1,00,000. Now your tax obligation on INR 1,00,000 is 0, as per section 112A, because the LTCG is less than the exempt value of INR 1,25,000.
| Year | Fund Value (A) | Capital gain in year (B) | Capital Gain Tax (C) | Post Tax Value (A + B – C) |
|---|---|---|---|---|
| 2020 | 10,00,000 | 1,00,000 | 0 | 11,00,000 |
| 2021 | 11,00,000 | 1,10,000 | 0 | 12,10,000 |
| 2022 | 12,10,000 | 1,21,000 | 0 | 13,31,000 |
| 2023 | 13,31,000 | 1,33,100 | 1012 | 14,63,088 |
| 2024 | 14,63,087 | 1,46,308 | 2663 | 16,06,733 |
| 2025 | 16,06,733 | 1,60,673 | 4459 | 17,62,947 |
| 2026 | 17,62,947 | 1,76,294 | 6411 | 19,32,830 |
| 2027 | 19,32,829 | 1,93,283 | 8535 | 21,17,577 |
| 2028 | 21,17,577 | 2,11,757 | 10844 | 23,18,490 |
| 2029 | 23,18,490 | 2,31,849 | 13,356 | 25,36,983 |
| 2030 | 25,36,983 |
Immediately, you repurchase the same number of units by reinvesting INR 11,00,000. Thereby raising the cost price for your new investment to INR 11,00,000 (and not the original INR 10,00,000). At the end of year 2, this new investment would have grown to INR 12,10,000. Repeat the same process and sell all your units to realize a capital gain of INR 1,10,000 (INR 12,10,000 – INR 11,00,000). Again there is no capital gain tax owed by you as the realized capital gain is less the INR 1,25,000.
| Details | Without Tax Harvesting | With Tax Harvesting |
|---|---|---|
| Cost of Investment in 2020 | INR 10,00,000 | INR 10,00,000 |
| Rate of Return | 10% | 10% |
| Total Capital Gains Tax Paid | INR 1,83,592 | INR 47,280 |
| Post Tax Value in 2030 | INR 24,10,150 | INR 25,36,983* |
| Net rate of tax | 13% | 3% |
Around the year 4, you will realize capital gains above the exempt limit of INR 1,25,000. From then on, you will pay a small amount of capital gains tax, and then reinvest the proceeds left over after taxation. Refer table below for detailed understanding. But even then you would have paid of total of INR 47,283 at the end of 10 years by realizing the capital gain every year and claiming the benefit of Section 112A every year. This amounts to a tax rate of 3%. Net proceeds available at the end of 10 years is INR 25,36,983, which higher by INR 1,26,833.
Do not forget to file your tax returns every year and claim the Section 112A benefits.