Tax-Loss Harvesting with Mutual Funds: Strategies for 2024

Mutual funds in India can do more than merely help you achieve your financial goals. When used strategically, mutual funds investments can also help you reduce your overall tax liability through tax-loss harvesting. In this article, we examine what tax-loss harvesting is and how mutual funds can play a crucial role in this strategic tax planning method.

What is Tax-Loss Harvesting? 

Tax-loss harvesting is the process of selling underperforming assets at a capital loss, so you can offset the capital gains from other investments and reduce your overall tax liability. The losses incurred from the sale of underperforming stocks or mutual funds can be used to reduce the taxable capital gains during the financial year.

The Income Tax Act, 1961, also contains provisions for carrying capital losses forward for a specified number of assessment years. So, you can use the tax-loss harvesting strategy to potentially reduce capital gains not only in the current financial year but also in the future up to the time limit specified.

Mutual Fund Tax Rates in India

To better understand how mutual funds can be incorporated into your tax-loss harvesting plan, you need to be aware of how these investments are taxed. Since mutual funds are capital assets, any profits (or losses) from these investments are categorised as capital gains (or losses).

They can further be classified as short-term capital gains (STCG) or long-term capital gains (LTCG) depending on their holding period. The table below summarises these details for different types of mutual funds (w.e.f April 1, 2023).

Type of Mutual Fund	Holding Period Less than 12 Months	Holding Period of 12 Months or More
Equity mutual funds	Short-term capital gains/losses	Long-term capital gains/losses
Debt mutual funds	Short-term capital gains/losses
Hybrid equity-oriented funds	Short-term capital gains/losses	Long-term capital gains/losses
Hybrid debt-oriented mutual funds	Short-term capital gains/losses

The tax rates on the profits, in turn, depend on the type of mutual funds and the nature of the capital gains, as outlined in the table below.

Type of Mutual Fund	Tax Rate on STCG	Tax Rate on LTCG
Equity mutual funds, arbitrage funds and mutual funds that invest at least 65% in equity	15%	10% without indexation benefits (on gains exceeding Rs. 1 lakh)
Debt mutual funds and floater funds	Applicable income tax slab rate
Conservative hybrid funds that invest less than 35% in equity	Applicable income tax slab rate
Conservative hybrid funds that invest more than 35% but less than 65% in equity	Applicable income tax slab rate	20% with indexation
Balanced hybrid funds	Applicable income tax slab rate	20% with indexation

Set-off and Carry Forward of Capital Losses

Once you understand how to set off and carry forward capital losses as per the Income Tax Act, you can formulate an effective tax-loss harvesting plan to reduce your capital gains tax. The following pointers are important in this regard:

• Intra-head Set-off: Generally, losses from one source or type of asset can only be set off against profits from the same source. For example, you can only adjust long-term capital losses from mutual funds against long-term capital gains. 

• An Exception to the Rule: A short-term capital loss is an exception to the above rule because it can be adjusted against both STCG and LTCG.

• Time Limit for Carry Forward: Both short-term and long-term capital losses can be carried forward for 8 assessment years, provided you file your Income Tax Return (ITR) within the due date.

How to Use Mutual Funds for Tax-Loss Harvesting: An Example

Now that you know how mutual funds are taxed and how the set-off and carry-forward of capital losses from mutual funds work, let us discuss a hypothetical example of tax-loss harvesting using MF schemes.

Say you have the following investments:

• Equity Mutual Fund A: 

• Purchased 1,000 units at Rs. 100 each
• Current value: Rs. 80 per unit
• Unrealised short-term capital loss: Rs. 20,000

• Debt Mutual Fund B: 

• Purchased 800 units at Rs. 200 each
• Current value: Rs. 210 per unit
• Unrealised short-term capital gain: Rs. 8,000

Here is what you can do to harvest your capital loss and reduce the capital gains tax for this financial year:

1. Step 1: Sell Equity Mutual Fund A, realising a capital loss of Rs. 20,000.
2. Step 2: Reinvest the proceeds in a similar equity mutual fund to retain your asset allocation.
3. Step 3: Offset the profit of Rs. 8,000 from Debt Mutual Fund B with the equivalent loss from Equity Mutual Fund A, resulting in zero net capital gains for the year.
4. Step 4: Carry forward the remaining Rs. 12,000 capital loss for up to 8 years to offset them against future gains.

Tax-Loss Harvesting Strategies with Mutual Funds

Now that you know what tax-loss harvesting is and how it works, here are some strategies that you can use to adopt this technique effectively.

• Pair Gains and Losses Smartly

Identify mutual funds that have unrealised losses and determine which unrealised gains can be set off using these losses. Even if excess losses remain after the adjustment, you can carry them forward as per the provisions of the Income Tax Act.

• Time Your Sales Well

To maximise your tax benefits, time your sales well. Ideally, the end of the financial year may be a more suitable time to carry out tax-loss harvesting because it is easier to assess your capital gains during the year, if any, and adjust them as needed.

• Utilise Both Long-Term and Short-Term Losses

Since LTCL can only be set off against LTCG, ensure that you utilise your long-term capital losses for this purpose. If any further LTCG remains, you can utilise your short-term capital losses too for tax-loss harvesting.

• Carry the Losses Forward 

While planning your mutual fund redemptions and capital gain adjustments, keep the buffer period of 8 assessment years in mind. Any excess gains can be carried forward up to this time limit. Also, ensure that you first set off older losses before using your current year’s losses.

• Review Fund Expenses 

When you select new funds to invest the proceeds from your mutual fund redemptions, consider the expense ratio involved. Choosing low-cost funds that align with your overall financial goals can improve your net returns and complement your tax-loss harvesting plan.

• Remember Your Financial Goals

While redeeming mutual funds at a loss may help you reduce the tax burden, you need to ensure that you don’t lose sight of your financial goals in the process. Redeeming too many investments merely to set off gains may interfere with your financial plan.