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Is tax harvesting a good idea?

Tax harvesting can lower your tax bill, but is it a worthwhile exercise?

Is tax harvesting a good idea?

The Union Budget in 2018 imposed a 10 per cent tax on long term capital gains (LTCG) on realised equity gains over Rs 1 lakh in a financial year. But there's an exception to it. The LTCG on equity up to Rs 1 lakh in a financial year is tax-exempt.

Tax harvesting is utilising the tax-free window of Rs 1 lakh to reduce overall LTCG tax. If you have invested and gained Rs 1 lakh, you can sell your investment, realise that gain, and invest it back without being liable to pay taxes. By doing so, your net investment remains unchanged, but you shield tax on long term capital gains worth Rs 1 lakh every year.

Let's take an example to understand this better. Suppose an investor has Rs 8 lakh invested in equity funds which gets appreciated to Rs 9 lakh. To shield the gains worth Rs 1 lakh from taxation, the investor would redeem Rs 9 lakh and re-invest it in equity. The investor won't have to pay tax on this Rs 1 lakh this year being exempted. And for future, the new cost of purchase would be considered as Rs 9 lakh, instead of Rs 8 lakh - shielding the complete gain of Rs 1 lakh from taxation.

Many investors might think that this is a very useful exercise to do. But that is not the case. We analysed the strategy in great detail in one of our older stories and compared two scenarios over a long period of 18 years. Check the story here. One scenario is where an investor follows tax harvesting and does all the hard work every year. The net proceeds were higher by only 3 per cent in case of tax harvesting. And in terms of the annual return, the difference was miniscule - just 0.29 percentage points.

A benefit of just 3 per cent for all the hard work that one may have to do doesn't seem rewarding enough. Tax harvesting needs a lot of effort and has its own set of complications too. To maintain continuity of investments, the investor will have to reinvest in equity funds as soon as the older units are redeemed for tax-harvesting. For this he must have a fat bank balance because the redemption proceeds usually take about three days to hit your bank account. And the NAV can surely change by that time. Besides, doing this exercise every year can be a hassle in itself.

So to conclude, for a retail investor, we don't think the gains from tax-harvesting are significant enough to justify the effort. Over the long term, the difference between those two methods is minuscule. But if you don't mind putting these many efforts for amount of gain you get, go ahead. The 'Tax' section in our portfolio tracker, 'My Investments' would help you.