Interactions with readers since Budget 2024 have made us realise that some investors are unaware of the difference between tax harvesting and portfolio rebalancing. One could also add “profit booking” into the mix. In this article, we explain the difference between these actions.
Profit Booking: This is a fallacy. You cannot redeem only profits from the capital markets. You buy at market price and sell at market price. So, any redemption will always have some part principal and some part capital gain.
The redeemed amount is pushed to fixed income instruments – savings account (where it waits for a “dip”) or FD or debt funds etc.
This is done with no specific portfolio management goal only because the profits “seem” high or the market overheated. Therefore, there is no way to assess the impact of this action. Most often, the primary benefit is the mental satisfaction of “quitting (in part) while ahead”.
Tax Harvesting: This is redeeming capital gains to the extent that they are tax-free (now Rs. 1.25 Lakhs) and reinvesting. The amount redeemed is reinvested in the same asset class immediately.
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We will refer to this as tax-gain harvesting to differentiate it from tax-loss harvesting – offsetting capital gain with an allowed capital loss. See: How to use MF and stock losses to reduce your tax burden (tax-loss harvesting).
Tax gain harvesting lowers the overall capital gains outgo during redemption. To understand how this works, consider this simple, naive example.
- I buy 1 unit of an MF or a share for Rs. 20,000
- Assume the price after 10Y is Rs. 2,00,000
- Without tax gain harvesting, the taxable capital gain is Rs. 1.8L minus 1.25L (as per current rules) = 0.55L
- Suppose I redeem when the price hits Rs. 1.45L and re-buy again at Rs. 1.45L (this is only theoretically possible, but let us dream on)
- My CG of Rs. 1.25L is tax-free.
- My final CG is now Rs. 2L – Rs. 1.45L = 0.55L, which is tax-free.
- So, instead of paying tax on 0.55L, tax harvesting results in no tax.
When put like this, it sounds wonderful. However, the sequence of equity returns and portfolio size will significantly diminish gains. In our opinion, tax-harvesting is an unnecessary act with marginal gains. Over the long term, such gains will be comparable to a portfolio’s typical daily loss or gain due to normal market movements.
Portfolio rebalancing: This is done to rest the portfolio’s current asset allocation to the target asset allocation. Here, redemptions are made from one asset class (which is doing well) and reinvested in another.
This is done to reduce the volatility in the overall portfolio’s value and returns and keep them close to the target value and return. It is, therefore, an essential step regardless of tax and exit load rules.
See for example:
- Forget tax and exit loads. This is why your portfolio should be rebalanced each year.
- What are the benefits of portfolio rebalancing?
- Fearing tax, I didn’t rebalance my portfolio in September 2021, and now I suffer higher losses!
- Can I rebalance my portfolio by adjusting my SIP amounts?
- Why portfolio rebalancing is important for investment success
- How to avoid rebalancing is the most common question we get!
- Portfolio Rebalancing: We answer frequent questions investors worry about (part 1)
- Portfolio Rebalancing FAQ Part 2
- Portfolio Rebalancing FAQ Part 3
In summary, do not waste time booking profits or harvesting gains. Have a goal, decide on an asset allocation for that goal, plan to reduce risk systematically, and invest and rebalance as per that schedule.
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