Optimise Your Returns By Tax Harvesting

If an investor can work the strategy of tax harvesting with normal portfolio re-balancing, it can be an excellent way to manage investments in a tax-efficient manner 



As we approach towards the end of the financial year, most of you must be looking at the performance of your portfolio and assessing the gain or loss generated by it. In the last one year, your large-cap dedicated funds might have given good returns, while the small-cap funds stand battered. Now, you see that a major part of your portfolio is tilted towards the large-cap and needs to be re-balanced. Calculating the gain or loss in your portfolio is easier part of the job, the difficult part is to re-balance and prepare your portfolio for the next year. In the process of rebalancing your portfolio (by selling large-cap funds and buying small-cap funds) you might end up recognising a significant taxable gain or may be even loss in case you sell your small-cap funds. Nevertheless, the loss that you may have in your small-cap funds is not as bad as you think. This is where the ‘tax-loss harvesting’ comes in. Even in the dark clouds of investment losses, there is a silver lining.

Tax loss harvesting is a practice of selling your mutual funds or equities or any other securities at a price below your purchase price. By ‘harvesting’ this loss, you are able to offset tax on some other capital gains. In our case, the profit accrued while selling large-cap funds can be set off by selling some of the small-cap funds. This will help you to lower your tax.

For example, in a given financial year, you have earned a short term capital gain (STCG) of  Rs. 2 lakh and also suffered a short Rs. term capital loss of Rs. 1 lakh.

When you do not take the advantage of ‘tax loss harvesting’, you need to pay tax of =2 lakh * 15% (tax rate of STCG) Rs. 30,000 

In case you take advantage of capital loss of 1 lakh, your tax liability will be =(2 lakh - 1 lakh )* 15%=  Rs. 15,000

Therefore, your tax liability declines by 50% if you take advantage of ‘tax loss harvesting’. 

Normally the ‘tax loss harvesting’ involves the following steps:

You identify investments that are underperforming and losing money. Moreover, you also need to evaluate if you need them anymore as they may not fit into your scheme of things or overall financial planning strategy. If they do not fit, sell these investments and book your loss.

Then, you use this loss to reduce your taxable capital gains, if any.

Finally, you reinvest the money that you got by selling your funds n into a different security that meets your investment needs and asset allocation strategy.

Tax Gain Harvesting

Tax loss harvesting is quite prevalent and is being used by smart investors around the world. Nevertheless, from this financial year, you may also take advantage of ‘tax gain harvesting’ to increase your post-tax returns. The budget 2018, after a gap of 14 years, reintroduced the tax on long term capital gains (LTCG) earned from stocks and equity mutual funds without any indexation benefit. However, an exemption of Rs 1 lakh is given to investors. So you will be taxed at a rate of 10% only if you book profit of more than Rs 1 lakh in a year.

This year, many of the investors (especially retail) might not have to pay this tax for two reasons. Someone who started investing in the last one year, chances are very low that your investment is in the green. The second reason is that even if you have been investing for long, January 31, 2018, has been taken as a grandfathered date. What this means is that acquisition cost of an asset for the purpose of computing capital gains will be the higher of the actual purchase price or the maximum traded price on January 31, 2018. In simple words, any gain made prior to that will not be taxed.

However, some of the smart investors may have shifted their portfolio towards large-cap funds and they may be sitting on their gains. So, what should they do with their gains? Simple answer: book profit and invest in them again. We will give the logic of this action through the following three cases.

Case I 

No Tax Gain Harvesting: Pay tax when you sell your units

In the first case, we assume that you do not want to go into the pain of first identifying and then buying and selling of MF schemes; rather, you remain invested till you have other reasons to sell. The following table shows how much tax you will pay in five years at different SIPs in case you remain invested for five years and sell after five years.



While preparing the above table, we have assumed that your investment grows at a rate of 12% every year. Therefore, if you are investing 5,000 every month, your total investment in five Rs. 3,00,000 (5000*12*5). This Rs. years would be 105,518 in five Rs. investment will generate a gain of years. After five years, you sell your entire 551.81 after getting Rs. investment and pay tax of 1 lakh (105,518.06-100,000 = Rs. exemption of 5518@10% = 551.8).

In case your investment amount is Rs. 50,000 every month, your gain will exceed Rs.1 lakh in the second year itself. Nevertheless, you sell your investments at the end of the fifth year when your have accumulated gain has been Rs. 10,55,180. In this amount, you need to pay tax of Rs. 95,518.06 based on the calculation explained above.

Case II

Limited Tax Gain Harvesting: Sell units whenever your gain exceeds Rs 1 lakh

In this case, we assume that you book profit on your investments only if you have profit of Rs. 1 lakh or more. So, in the above table, even if you are generating profit from the first year itself, you do not book profit till the fifth year, when you sell your entire units. Then you pay tax based on the realised gains after five years.

However, in this case, you book profit as soon as your net profit exceeds Rs. 1 lakh. In the above table, you can see your gain exceeds Rs. 1 lakh in the second year itself, if your SIP amount is Rs. 50,000. Hence, you will reset your portfolio in the second year itself, when your accumulated gain is Rs. 153,248. You will sell your entire portfolio and purchase the same units again. This will help you to book profits and reset your portfolio with higher cost of acquisition. Similarly, in case your SIP is Rs. 30,000 every month, you need to reset your portfolio in the third year. If you continue to do so, your tax liability will be reduced by Rs. 30,704 in five years in the case of SIP of Rs. 50000. The table below illustrates the entire process and the amount of tax you need to pay in five years. 



The tax difference between Case I and Case II is as following:



Therefore, by following this strategy, you could save tax up to one per cent of your total investment in five years.

Case III

Full tax gain harvesting: You book profit every year and reset your portfolio irrespective of how much your portfolio has gained

This is the most actively managed tax harvesting strategy. You reset your portfolio every year by selling your investments and then reinvesting in them, irrespective of the gain you have in your portfolio. You will not wait until your investment gain reaches Rs. 1 lakh. Our analysis shows that this gives you the best post-tax returns. The reason being it helps you to take advantage of capital gain exemption every year. Since this exemption is not carry forward and lapses every year, it is better to take advantage of the exemption every year. Following table illustrates the how the gain works out:



In the above table, the gain changes from the previous table every year, except for the first year because last year's sales price becomes purchase price of the current year and hence every year gain is lesser than the earlier two cases. This has led to lower tax incidence in this case.



The table above shows the tax you need to pay over five years following the different strategy.

The Practical: Do It Yourself

Although the third case looks promising and saves your tax the most, implementing it is a little tedious, especially when you are investing through SIP. This is because you need to track the movement of NAVs at which you invest every month. The reason being if you sell your equity MF units before one year, you will have to pay a short term gain tax (if any), hence you will have to wait for at least one year before you could sell your equity MF units to avail the LTCG tax exemption. It will also help you to avoid any exit load, as most of the equity funds do not impose exit load after one year.

MF investment assumes redemption of units on FIFO (first in, first out) basis. Hence, the units purchased first are redeemed first, and you have to pay the appropriate short/long term capital gains tax on any profit. So, for an SIP that ran from January to December, if you sell some of the units, then you are taxed for your January units first and your December units last.

For example, you invest in a fund at a NAV of Rs. 10 in the month of January and Rs. 12 in the month of February, and so on, for the entire year. Next year in the month of January, when you sell your MF units, to calculate tax it will first consider the NAV of January and the number of units purchased during January. Therefore, this method will require you to keep accurate cost basis record for all of your MF unit purchases. However, the savings in tax makes it worth the effort.

In order to implement the third case, we have taken an example of a multi-cap fund that has been in existence since 2008 and the recent rationalisation and categorisation has not changed its investment style. We took its monthly NAV since January 2010 and assume that your SIP date is the start of the month. Hence, your first purchase will be at NAV prevailing on January 1, 2010 and you get ‘x’ units. Now you need to sell these unit in January next year and repurchase them the next day, without disturbing your normal SIP. This will help you to avoid tax on short term capital gains (if any). You need to continue this every month. That is, in the month of February next year, you will sell the units purchased in the month of February this year. You will continue to do so till you finally stop investment. In-between, you can also change the funds as it is not going to impact much till the time you keep track of your investment properly and time the sale properly.

We followed the above strategy for the next eight years, that is, till the end of 2018. Our actual investment was Rs. 10.80 lakh, assuming SIP of Rs. 10,000. The fund value after nine years, after booking profit every year (there were couple of years when there were negative returns and hence there were no profits), was Rs. 21.18 lakh after deducting all the LTCG tax.

In case you remain invested without booking profits every year, your fund value will be Rs. 20.66 lakh at the end of the year 2018. However, if you pay tax on the gain made on this investment, you will get net value of Rs. 19.77 in hand.

Therefore, the net profit you get on your investment of Rs. 10.8 lakh in nine years is Rs. 1.4 lakh, which is 13% of your investment value. Hence, if you follow this strategy, you can earn post-tax return of almost one per cent more than following the simple buy, hold and sell strategy. 

Steps involved for tax gain harvesting

The ‘tax gain harvesting’ involves the following steps:

You identify equity MF investments that have completed one year and are in profit.
You book profit in the fund and repurchase it again
Use this profit to take advantage of Rs 1 lakh exemption provided in case of LTCG tax.
You can also purchase different funds from the sale proceeds

Capital Assets and STCG tax and LTCG tax and set-off rules

Capital assets are of two types, short term capital asset and long term capital asset. Short term capital assets are those assets that are held for less than 36 months in most of the cases, however, in case of shares and equity mutual funds, 36 months is substituted by 12 months. Hence, if you keep an equity mutual fund for more than 12 months, it is a long term capital asset. In case of debt, you need to hold it more than three years to make it a long term asset, otherwise it is short term capital asset.

Capital Gains: Any profits or gains arising from the sale of a capital asset shall be chargeable to income-tax under the head 'capital gains'.

Short term capital gain: Capital gain arising on sales of short term capital asset.

Long term capital gain: Capital gain arising on transfer of long term capital asset.

Set-off rules

Long term capital Loss can be set off only against long term capital gains. Short term capital Losses are allowed to be set off against both long term gains and short term gains. If you are not able to set off your entire capital loss in the same year, both short term and long term loss can be carried forward for eight assessment years immediately following the assessment year in which the loss was first computed.

Conclusion:

Tax harvesting is believed to have a significant positive impact on investment returns over the long run. Since the process is complex and it has been calculated on the basis of NAV movement of the fund, it is hard to pin down and generalise the definitive percentage improvement in the performance.

Nonetheless, our analysis shows that it definitely improves your post-tax returns. What we have followed is a simple investment strategy, if you also include tax loss harvesting along with tax gain harvesting, the post-tax returns will definitely be superior to simple buy, hold and sell strategy.

Tax (loss/gain) harvesting like any other strategy should be guided by your overall financial planning and investment goals. Keeping track of your investment is bit difficult if you have more than five SIPs as this strategy becomes tedious as your number of SIPs goes up. That said, if you can work this strategy with your normal portfolio re-balancing, it can be an excellent way to manage your investments in a tax-efficient manner.