How do I redeem equity funds while avoiding taxation?

While equity mutual fund investments allow you to earn high profits, the earned profits are subject to taxation. Note that long-term capital gains (LTCG) of over Rs 1 lakh on redeeming equity investments are taxed at 10 per cent without any indexation benefit. However, with proper planning, the taxation figure can be lowered considerably.

How to lower LTCG on your mutual fund returns?

As mentioned above, long-term capital gains on equity funds are taxable just if the returns on your equity investments surpass Rs 1 lakh figure in a financial year. So, if your LTCG in a financial year from equity funds is below or equivalent to Rs 1 lakh, then capital gain tax is not levied. Thus, to save your capital tax, you can take the help of tax harvesting approach in equity funds.

How does the tax harvesting approach assist you to lower your capital gain tax?

If you have invested a very small amount in equity mutual funds, then the LTCG returns from investments may be below Rs 1 lakh. Here, in this case, you will not be charged a tax on redemption. However, if you continue adding to your equity investments, then your returns may grow, which may generate over Rs 1 lakh returns, which is taxable.

The table below represents how soon your equity returns may surpass the Rs 1 lakh limit in the case of a lumpsum amount investment assuming the annual return is 13 per cent per annum on your investments –

As you can see, for the lumpsum investment equaling Rs 1 lakh, the LTCG will surpass Rs 1 lakh mark post 5 years. However, for the bigger lumpsum investment figures like Rs 2 lakh, 3 lakh and 4 lakhs, the time taken for LTCG to surpass Rs 1 lakh mark is 5, 3, and 3 years, respectively.

With the tax harvesting approach, you can sell your equity fund units every year and reinvest them in the same scheme to avoid incurring long term capital gain tax. To understand this approach better, consider the example given below.

Suppose you invested Rs 5 lakh in an equity fund on 1^st January 2021 and received a 12 per cent annual return on your equity investment. Now on 1^st February 2022, your investment returns and your capital gains may appear as follows –

Now, if you liquidate your investments as on 1^st February 2022, you will not be required to pay long-term capital gain tax as the gains are Rs 60,000 and equity returns in a financial year of up to Rs 1 lakh are tax free.

Next, you must reinvest the overall proceeds in the same scheme. On investing Rs 5,60,000 on 2^nd February 2022 at an assumed return rate of 12 per cent, your investment may grow as follows within 1 year –

Now, you can again liquidate your equity investment. As your equity investment is completed in 1 year, it will fall in the LTCG category. And here, you will not be required to pay any capital tax as the gains are Rs 67,200, which is again less than Rs 1 lakh limit.

Now, suppose if instead of liquidating your equity investment that you invested on 1^st January 2021, you remained invested and allowed your initial amount of Rs 5 lakh to grow until 1^st February 2023. In such a case, you may witness the following –

From the above, it must be clear that by using the tax harvesting approach, you can avoid paying LTCG tax on your equity fund investments. The tax harvesting approach also works when you opt for the SIP mode of investment in mutual fund. Under SIP mode also, you must liquidate the equity units that qualify for LTCG and reinvest the proceeds to avoid the 10 per cent LTCG tax.