Book gains as price/NAV moves up, and buy the same share/MF scheme. It creates a higher acquisition cost for your ultimate taxation, when you sell the investment after an adequate period of holding.
When it comes to tax planning, people think of Section 80C and other investments. What we will discuss now is different; it will give you tax benefit, not today, but in the future. This is in the context of your investments in equity mutual funds and/or equity stocks. In equity funds growth option / equity stocks, it becomes long term from the tax perspective after a holding period of one year. The taxation rule is, on your gains you pay tax at 10% plus surcharge and cess as applicable, on gains more than Rs 1 lakh per financial year. That is, up to Rs 1 lakh of long term capital gains (LTCG) per year is free from tax; beyond that you pay 10%.
How it works
There is a way of generating tax efficiency. Since equity investments are meant for the long term horizon, you effectively stay invested. As and when the price / NAV moves up, you can sell (i.e. book the gains) and purchase the same share / MF scheme. How does it help? It helps to create a higher acquisition cost for your ultimate taxation, when you sell the investment after an adequate period of holding.
For taxation of equity, January 31, 2018 is known as the ‘grandfathering date’ i.e. prices / NAVs prior to this date are not relevant and price on this date becomes the cost of acquisition. Let’s say the price/NAV as on January 31, 2018 was Rs 100 and you would eventually sell it after 10 years when the price would be, say, Rs 200. At that point, you would pay tax on Rs 200 minus Rs 100 = Rs 100. You would pay tax in that financial year (as per current rules), on the gains more than Rs 1 lakh. Let us say today, after the rally in equities, price/NAV has moved up to say Rs 130 as on December 2020. Today, if you sell the share / MF scheme at Rs 130 and purchase it again, as long as the gains, i.e., Rs 130 minus Rs 100 = Rs 30 is within Rs 1 lakh in the financial year, it is tax free for you.
Through this transaction, your cost of acquisition for tax purposes moves from Rs 100 to Rs 130, which will be relevant when you eventually sell it after another, say, seven years at Rs 200. At that point, your gains will be Rs 200 minus Rs 130 = Rs 70 instead of Rs 100. Let’s say you invested Rs 10 lakh in equity MFs more than one year ago and the portfolio value today is Rs 10,80,000. You can redeem the entire portfolio as the gains are within Rs 1 lakh. If the market value of the portfolio today is, say, Rs 12 lakh, then for executing this strategy, you have to sell as much so that your gains are within Rs 1 lakh to avoid tax.
This discussion assumes you invested in the fund lump sum and exited on a particular date. However, you may have invested through a Systematic Investment Plan (SIP) and may withdraw through a Systematic Withdrawal Plan (SWP). In that case, NAV of your earliest investment will be taken, which is called First In First Out (FIFO). For example, if you did an SIP from January 1, 2019 to January 1, 2020 and exit today, the acquisition NAV as on January 1, 2019 will be relevant and then the next instalment will be considered. If you do an SWP from January 1, 2021 onwards, the earliest investment will be considered for taxation, for every exit.
Maximising gains, minimising tax
The taxation rule is, on your equity gains, you pay tax at 10% plus surcharge and cess as applicable, on gains more than Rs 1 lakh per financial year
Sell in a market rally as much so that your gains are within Rs 1 lakh to avoid paying tax and reinvest in the same shares to increase your acquisition cost for final sale at a later period
If you have invested through a SIP and withdrawn through SWP, NAV of your earliest investment will be taken, which is called First In First Out.