What is Tax Loss Harvesting?

5paisa Research Team Date: 14 Mar, 2024 12:05 PM IST


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Many individuals are unaware that they could actually profit from a decline in the portfolio asset's value. It is possible to use the tax loss harvesting technique. This is a great strategy to improve your post-tax profits on investment. Tax-loss investing can enhance wealth generation even if it works in an indirect manner, particularly in the early stages of a portfolio's existence. Here is more information on what does tax loss harvesting mean.

What is tax loss harvesting?

You may ask, what is tax loss harvesting? Investing in mutual funds with an equity focus might result in financial losses or gains. These are classified as either long and short term depending on how long you want to keep your fund units. 

Investors can offset capital losses against capital gains to lower their tax obligations, according to the Income Tax Department. This indicates that you only have to pay tax on the net gain of Rs. 40000 (50k – 40k) when you have short-term capital losses of Rs. 10000 and gains of Rs. 50000 in a given financial year.
Selling stocks and equity fund units having little to no probability of rising from the current levels at a loss is known as tax loss harvesting. 

This lessens the need to pay capital gains taxes. The majority of investors attempt to harvest the capital losses at the financial year's end. Then, you may utilise it on a monthly basis to keep the amount of your yearly capital gains modest.

How does Tax Loss Harvesting work?

1. Recognise your underperforming investments particularly in the context of the market slump: Find out which of your portfolio's investments have lost value first. These investments could be in the form of mutual funds, equities, bonds, or other securities.
2. Sell for a capital loss: Sell the loss-making investments to recover the loss, which means offering them for less than what you paid for them.
3. Reduce taxes and save money: Capital losses can be used to reduce or even eliminate taxes due to higher-valued assets. If your capital losses exceed your earnings, you may carry them forward for up to eight assessment years.
4. Reinvest the money you save in a profitable asset that aligns with your investing plan. This will strengthen the position of your portfolio.

Benefits of Tax Loss Harvesting

The following are some benefits of tax loss harvesting meaning and ways in which taxpayers might save taxes:
Postpone paying your tax liabilities - Prior to investing, the majority of investors do not schedule their exit. You can save time and money if you want to invest for ten years or longer. You can also pay less taxes on your assets and profit from long-term capital gains. By extending the time you have to keep your investments, you can also delay your tax obligation.
Cross-Asset Benefits for Diverse Portfolio - Tax loss harvesters can benefit from cross-asset benefits and maintain a broad portfolio. The taxpayers can offset the tax obligations of lower-tax asset classes against the tax obligations of higher-tax asset classes. Taxpayers are also able to deduct the loss on the sale of one asset from the gain on the sale of another. This lowers the total amount of capital gains tax due.
Investment Benefits for Short-term and Long-term - By using tax-loss harvesting, you can avoid paying STCG at the rate of 15%. Short-term losses might be deducted from short-term gains. Even if these investments become lucrative over time and become long-term assets, your tax liability will still be computed at 10%.

Tax Loss Harvesting Example

Let's illustrate tax loss harvesting definition with an example. Assume your portfolio generated Rs 1,00,000 in short-term capital gains and Rs 1,05,000 in long-term capital gains during a particular fiscal year. The short-term capital losses were Rs 50,000.

Tax payable (Without tax loss harvesting) = [(Rs 100,000 * 15%) + {(105,000-100,000) *10%}] = Rs 15,500
Tax payable (With tax loss harvesting) = [{(Rs 100,000-Rs 50,000) * 15%)} + {(105,000-100,000) *10%}] = Rs 8,000
The computations may appear complicated and time-consuming. You may receive help managing and submitting LTCG tax from a competent accountant. The proceeds from the sale of a loss-making stock/equity fund can be utilised to purchase a profitable stock or equity fund. This type of replacement is important to maintain the portfolio's original asset allocation. 

Moreover, it maintains the portfolio's risk-return profile. Among other things, tax-loss harvesting is an important technique for saving a lot of money on taxes. You'll also learn how to diversify your portfolio for improved results. It cannot compensate for the losses, but it can alleviate your sorrow by allowing you to save taxes.

Tax gain and loss harvesting are simple but efficient techniques to reduce the taxes you'll pay on your equity investments. Remember, you must reinvest the money as soon as you get the redemption amount in your account or risk breaking your compounding path.

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