Tax Harvesting : A simple strategy to lower your taxes

If you're new to investing or just starting your journey in the stock market, you might have come across the term tax-loss harvesting. It may sound complicated, but don’t worry! By the end of this post, you’ll understand what tax-loss harvesting is, how it works, and how it can help you save on taxes and grow your wealth.

What is Tax?

Tax is a financial charge imposed by the government on individuals, businesses, and transactions to fund public services and infrastructure development. In the context of the Indian stock market, various types of taxes apply based on the nature of income generated, including capital gains tax, dividend tax, and securities transaction tax (STT).

Types of Taxes on Stock Market Income

1. Capital Gains Tax

When you invest in stocks (equity shares listed on a stock exchange), the time you hold them before selling decides how the government taxes your profits or losses. There are two types: Short-Term (if you sell within 12 months) and Long-Term (if you sell after 12 months).

Short-Term Capital Gains (STCG) and Losses (STCL)

• If you sell stocks within 12 months and make a profit (selling price is higher than buying price), it’s called a short-term capital gain.
• If you sell at a loss (selling price is lower than buying price), it’s a short-term capital loss.
• Tax on short-term gains: It used to be 15%, but from July 23, 2024, it’s now 20%. So, quick profits cost you more in taxes now.
• Losses: If you have a short-term loss, you can use it to reduce your tax on any short-term or long-term gains. If you can’t use it all in one year, you can carry it forward for up to 8 years to lower future taxes.

Long-Term Capital Gains (LTCG) and Losses (LTCL)

• If you hold stocks for more than 12 months and sell them, it’s either a long-term capital gain (profit) or long-term capital loss (loss).
• Before 2018, long-term gains on stocks were tax-free. But since the 2018 Budget, that has changed.
• Old rule: Profits up to ₹1,00,000 are tax-exempt, and if your profit exceeds ₹1 lakh, you must pay a 10% tax on the amount over & above
• New rule (from July 23, 2024): The tax-free limit is now ₹1.25 lakh (up from ₹1 lakh), but the tax rate is higher at 12.5%.

Example: If your gain is ₹5,00,000, you subtract ₹1,25,000 (tax-free part), and pay 12.5% tax on ₹3,75,000. That’s ₹46,875 in tax.

• Losses: If you have a long-term loss, you can carry it forward for 8 years to reduce future long-term gains. But you must file your tax return on time to do this.

In short: Quick trades (under 12 months) are taxed at 20%, while longer holds (over 12 months) get a tax break up to ₹1.25 lakh, with 12.5% tax on profits above that. Losses can help lower your taxes if you use them wisely!

Grandfathering Clause

A grandfathering clause allows certain people or situations to follow old rules, even after new rules are introduced. Those who get to keep the old rules are said to have grandfather rights or are grandfathered in.

Until the 2017-18 fiscal year, long-term capital gains (LTCG) from the sale of listed equity shares were tax-free.However, the Finance Act, 2018 reintroduced the LTCG tax, effective April 1, 2018, for the 2018-19 fiscal year and beyond. To ease the transition, a grandfathering clause was introduced.

How the Grandfathering Clause Works

Although the LTCG tax was reinstated on February 1, 2018, the Central Board of Direct Taxes (CBDT) allowed for gains accrued up to January 31, 2018, to remain tax-free.

Grandfathering Clause Formula

The acquisition cost is determined using the following approach:

1. Value I = Lower of:
   

   1. The Fair Market Value (FMV) as of January 31, 2018, or
   2. The actual selling price.

2. Value II = Higher of:
   

   1. Value I (from Step 1), or
   2. The actual purchase price.

3. Long-Term Capital Gain (LTCG) = Sales Value - Acquisition Cost (as per the above calculation).
4. Tax Calculation:
   

   1. LTCG of up to ₹1 lakh per year is tax-free.
   2. Any LTCG above ₹1 lakh is taxed at 10% (plus applicable surcharge and cess).

Example Calculation

• Purchase Price = ₹100 (Acquired on January 1, 2017)
• FMV on January 31, 2018 = ₹200
• Selling Price = ₹50 (Sold on April 1, 2023)

Using the grandfathering clause:

• Value I = Lower of Selling Price (₹50) and FMV (₹200) → ₹50
• Value II = Higher of Value I (₹50) and Purchase Price (₹100) → ₹100
• Acquisition Cost = ₹100

Thus, Long-Term Capital Loss = ₹50 (₹50 - ₹100).

This means the investor incurs a capital loss of ₹50, which can be set off against other taxable gains.

2. Dividend Income Tax

When companies share their profits as dividends, the investor must pay tax on this income. The tax is applied based on the investor's income tax slab rate.

A 10% TDS (Tax Deducted at Source) is applied if the dividend income exceeds ₹5,000 in a financial year.

3. Securities Transaction Tax (STT)

STT is levied on the purchase and sale of equity shares and equity mutual funds on recognized stock exchanges.

Rate: Generally around 0.1% of the transaction value, depending on the type of transaction.

What is Tax Harvesting?

Tax harvesting is a strategy used by investors to reduce their tax liability by strategically selling shares. This technique primarily involves two methods:

1. Tax-Loss Harvesting: Selling shares at a loss to offset taxable gains.
2. Profit Harvesting: Selling shares at a high profit and rebalancing the portfolio.

Let's explore these concepts in detail.

1. Tax-Loss Harvesting

Tax-loss harvesting involves selling shares that have declined in value to realize a loss. These losses can be used to offset capital gains, thereby reducing your taxable income.

How Does Tax-Loss Harvesting Work?

• Sell underperforming assets: Identify shares with unrealized losses.
• Offset gains: Use the realized losses to offset gains from other shares.
• Carry forward losses: If losses exceed gains, you can carry them forward for up to 8 years in India.

2. Profit Harvesting

Profit harvesting is about selling shares when they hit a high-profit point to lock in gains. The investor can then rebalance the portfolio by reinvesting in low-risk stocks or diversifying stocks.

When to Use Profit Harvesting?

• During market peaks or when stocks are overvalued.
• To rebalance your portfolio and maintain your investment strategy.

3. Dividend Harvesting

Some companies distribute dividends as a share of their profits. Dividend harvesting involves buying stocks before the dividend date and selling them after receiving the dividend, providing investors with an additional income stream.

Tax-Loss Harvesting: A Detailed Example

Arun's Investment Strategy

• Arun holds Share A (Long term capital gains of ₹2,00,000) and Share B (Long term capital loss of ₹90,000).
• Without tax harvesting, his tax calculation would be:

Taxable Gain: ₹2,00,000 - ₹1,25,000 = ₹75,000 (Excess over exemption)
Tax Payable: ₹75,000 × 12.5% = ₹9,375

With Tax-Loss Harvesting Strategy:

1. Arun sells Share B to book a loss of ₹90,000.
2. His net capital gain is now:

₹2,00,000 (Profit from Share A) - ₹90,000 (Loss from Share B) = ₹1,10,000

Since ₹1,10,000 is below the ₹1,25,000 lakh exemption limit, Arun pays no tax!

Pro Tip:

After selling Share B, Arun can reinvest in the same stock when the new financial year starts if he believes in its potential growth.

Important Rules for Tax Harvesting

• Long-Term Capital Losses (LTCL) can only be set off against Long-Term Capital Gains (LTCG).
• Short-Term Capital Losses (STCL) can be set off against both LTCG and STCG.

Why is Tax Harvesting Important for Investors?

1. Reduce Your Taxable Income

If you made a profit on one stock and lost money on another, selling the losing stock can reduce your tax liability.

2. Develop Good Investment Habits Early

• Helps you save more money in the long run.
• Makes you a smart investor who understands market strategies.
• Builds long-term wealth through wise financial planning.

3. Leverage Time and Compound Interest

If you’re just starting to invest, the money saved through tax-loss harvesting can be reinvested. Over time, this money can compound significantly, boosting your wealth.

Common Mistakes to Avoid in Tax Harvesting

1. Messing Up the Short-Term vs. Long-Term Thing

The clock matters. Sell a stock in under 12 months? That’s short-term. Hold it longer? It’s long-term. If you don’t keep track, you might assume a loss can offset any gain, but it’s not that simple. Short-term losses are flexible—they can cancel out short-term or long-term gains. Long-term losses? They only play with long-term gains. Sell at the wrong time, and you could miss the tax savings you were counting on.

2. Losing Track of What You Paid

You can’t figure out your gain or loss without knowing your starting point—what you paid for the stock.If your records are a mess (say, you forgot bonus shares, split shares, dividends received), your math’s off. That means you might overpay taxes or miss a chance to offset gains. Keep it simple,note down your buy price and extras so you’re not guessing later.

3. Procrastinating ‘Till Crunch Time

Don’t wait until the end of the year to harvest those losses. Stocks don’t care about your calendar—they’ll move when they move. If you sit on your hands too long, that loss you wanted might flip into a gain, or shrink to nothing. Check your portfolio regularly, spot the losers early, and act when it makes sense—not when you’re racing the tax deadline.

4. Dumping Good Stocks Just for a Tax Win

Here’s a trap: You sell something at a loss to save on taxes, but it’s actually a gem that could’ve grown big. Sure, you shaved a few bucks off your tax payable, but you might’ve kissed goodbye to way more in profits. Before you sell, ask yourself: Is this stock a dud, or am I just chasing a quick tax fix? Don’t let a small win cost you a big one.

5. Letting Losses Expire on You

In India, you get 8 years to use your losses to cut future taxes—pretty sweet deal right, But if you don’t file your tax return on time, or you forget about them, they vanish. It’s like leaving cash on the table. Stay organized, know what losses you’ve got in your back pocket, and use them before they’re history.

6. Going Solo Without a Clue

Tax rules aren’t static—look at 2024, with short-term rates jumping to 20% and long-term to 12.5%. If you’re winging it without checking the latest, you might miss a new limit (like the ₹1.25 lakh long-term exemption) or misstep.

Smart Trick: Book Profits Annually

Instead of waiting to book a big profit all at once, try to book profits every year up to ₹1.25 lakh.

• Gains up to ₹1.25 lakh are tax-free, so you won’t pay any tax.
• This lets you use the tax exemption every year and avoid extra taxes if your profits go over the limit.

Conclusion: Tax Harvesting = Smart Money Move

Tax harvesting isn’t just for rich people. It’s a smart way for clever investors to grab every chance to grow their money over time, even by small amounts.

• Always track your gains and losses.
• Use tax harvesting to reduce your tax payable.
• Reinvest your savings to build long-term wealth.

By understanding tax harvesting early, you’ll stay financially ahead and save a lot of money over your lifetime.

FAQ: Tax Loss Harvesting Basics

1. What is tax loss harvesting?

It’s a strategy where you sell an investment that’s lost value (like a stock or fund) to lower your taxes. You use that loss to cancel out taxes you’d owe on profits from other investments.

2. How does it save me money?

If you made money selling one stock (a gain), you’d owe taxes on it. Selling something else at a loss lets you subtract that loss from your gain, so you pay less tax or none at all if the loss covers it.

3. Who can use tax loss harvesting?

Anyone with a taxable investment account (not a retirement account like an IRA or 401(k)) can do it. It’s most helpful if you have gains to offset or expect to in the future.