Tax Gain Harvesting: What's the Deal?

by Michael on Nov 28, 2012 · 1 comment

Photo of Combine Harvesting a Crop

While tax loss harvesting is a familiar concept that is employed by many seasoned investors, I’d bet that far fewer are familiar with — or fully appreciate — tax gain harvesting.

With tax loss harvesting you’re turning lemons into lemonade by locking in (paper) losses to offset gains, or even ordinary income.

In contrast, with tax gain harvesting you’re strategically realizing gains when it’s advantageous to do so. Under what circumstances might you choose to do this?

I’m glad you asked…

Pay nothing in taxes

As the tax code is currently written, individuals in the 10% and 15% tax brackets pay 0% on long-term capital gains. Thus, it makes sense to sell appreciated investments and then re-buy them, effectively resetting the cost basis to a higher level without actually paying any additional taxes.

Note: There’s no reason to be concerned about a wash sale here because wash sales only apply to cases where you sell a security at a loss.

If you do this, just be careful not to push yourself into the 25% tax bracket, at which point you would have to pay 15% capital gains taxes on a portion of the gain.

This is really a no-brainer, but the 0% tax rate on long-term capital gains is set to expire at the end of 2012 so you may or may not be able to take advantage of this going forward. It all depends on the fiscal cliff negotiations.

Pay less in taxes (maybe)

Speaking of the fiscal cliff… If/when the Bush era tax cuts expire at the end of the year, the 0% LTCG rate is going away (as noted above) and the 15% LTCG rate will change to 20%. This is still better than tax rates on ordinary income, but it’s certainly not as good as the current situation.

On top of the (possibly, if Congress doesn’t act) higher LTCG tax rate, individuals with an adjusted gross income (AGI) of $200k or more ($250k for married couples filing jointly) will face an additional 3.8% tax on “unearned” (investment) income, including capital gains, as a byproduct of the Affordable Care Act.

Note: This additional tax only applies to unearned income to the extent that it exceeds $200k (or $250k), so it’s not as bad as it sounds.

So, this begs the question…

Should you harvest gains?

If you expect to be in the 10% or 15% tax bracket, then (as I said above) it’s a no-brainer. You really can’t lose as you’ll owe nothing in additional taxes and you’ll increase your cost basis, thereby reducing future taxable gains.

If you’re in a higher tax bracket, then it’s not quite as clear. Yes, you might dodge an extra 5% in capital gains taxes, but… Don’t forget that the the LTCG rate was set to increase from 15% to 20% two years ago and that never came to pass.

In other words, you might wind up paying taxes sooner than needed for no reason.

The additional 3.8% tax for high earners does add some complexity, but still…

I’m in my early 40s and I fully expect the tax landscape to change again (and again, and probably again) before I need to cash out. Thus, it’s hard to justify choosing to pay taxes now in fear of a possible increase in the LTCG rate next year along with a smaller new tax that may or may not still be there down the road.

My general rule, at least in taxable accounts, is to avoid paying taxes for as long as humanly possible. Roth IRAs are a different beast entirely and are (currently) the one area where I’ll consider breaking this rule.

1 Kurt @ Money Counselor November 28, 2012 at 10:23 am

Excellent advice that could save thousands for those in the lower tax brackets. I didn’t know the wash sale rule applies only to selling at a loss, so thanks for that! And I agree–in general, defer paying taxes as long as possible rather than trying to predict your tax-rate future.

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