Minimizing your taxable liability on investments allows you to save more towards your goals. Most people often invest in retirement accounts. That means most don’t need to establish a tax harvesting strategy. For people who invest in taxable accounts, a tax loss harvesting often comes to mind. Tax gain harvesting is the opposite of a tax loss strategy. It may seem counterintuitive to sell securities to create a taxable gain, but this strategy could save you thousands over the life of your account.
In this article, I’ll explain how tax gain harvesting works. As you may know, the Internal Revenue Code is riddled with what some call ‘loopholes’. The reality is that many of these so-called loopholes are just incentives to behave in a certain fashion. Tax gain harvesting is an incentive offered to encourage investment from those who have lower incomes.
Retirement accounts are a prime example of tax incentives. The government knows that Social Security can’t cover everyone’s needs in retirement, so they reward you for saving on your own. If you put money away for retirement, the government gives you some sweet tax breaks.
Retirement accounts can be Individual Retirement Accounts (IRAs) in the traditional or Roth tax structure, SIMPLE and SEP plans for the self-employed, or employer sponsored plans such as a 401(k), 403(b)7, 401(a), 457 type investments. These accounts can best be thought of as buckets that hold your money. Each bucket has a different use and purpose.
Among the different tax incentives offered is the fact that the sale of investments avoids capital gains tax as long as that sale occurs inside of the tax-sheltered account. This allows an investor to easily change an investment portfolio without worrying about the tax consequences. Outside of a retirement account, you need to be mindful of what you do.
To understand tax harvesting, you first need to understand capital gains. Capital gains are yet another incentive for good tax behavior. Capital gain tax rules incentivizes people to invest for the long haul. The government wants people to use their money to help businesses. On the other hand, capital gain rules punish those trying to earn a quick buck by taxing them more.
Here’s how capital gain taxes work. As an example, let’s say you buy stock in XYZ Corp for $10 a share. After a while, you decide to sell the stock when it reaches $15 a share. The government somehow already got their cut of your initial $10 investment… but they want a piece of the extra $5 you earned by putting your money to work.
How much the IRS takes depends on how long you held onto the investment and how much you earned during the year. To start with, we need to break down the short and long-term capital gain rates. Remember, the IRC encourages you to invest… and that means you get a break if you hold your investments long term.
An investment is considered short term if you hold it for one year or less. Short term capital gains are taxed at your ordinary income tax rate. In simple terms, the gain on the sale is added to the amount you claim as income for the year. The chart below details the 2018 tax brackets short term capital gains are taxed at.
The short-term capital gain rate is higher than the incentive offered to those that hold onto investments for over one year. If an investor commits their funds to the investment for over one year, they will pay the lower long-term capital gain rate below. This rate can be half as much as the short-term rate. Depending on your income, you may owe nothing on the gain of the sale. We’ll come back to that point later on when we discuss the tax gain harvesting strategy later.
Tax Loss Harvesting
Tax loss harvesting is a popular strategy that helps reduce your overall tax burden. The capital gain rules allow you to offset the taxable gains from one investment sale with the taxable losses on another sale made during the tax year. These rules are divided by short-term and long-term capital gain sales. Short-term capital gains and losses offset each other to reduce gains taxed at the ordinary rate. The same applied to long-term capital gains, which offset each other for the long-term rate.
In the example above, the illustration presents two different scenarios. In the first one, the investor sells a stock with $20,000 in capital gains. At a projected combined federal and state tax rate of 35%, this creates a taxable burden of $7,000. In the other illustration, the investor offsets that gain by selling a stock that has lost $25,000 in value. The result is a reduction in their taxable burden.
The illustration points out an important limitation of the tax loss strategy rules. Tax losses are capped at $3,000 per year, although excess losses can be carried forward to future years. Another limitation is the wash sale rule, which prevents you from buying and selling the exact same security within a 30-day period. These rules were put in place to discourage the abuse of the tax incentives offered.
Tax Gain Harvesting
Tax Gain harvesting is a different approach that works for a select group of investors. When used properly, it can greatly reduce the overall tax burden. Tax gain harvesting taxes take advantage of the fact that long-term capital gains are taxed at 0% for those falling in the (for 2018) 10% and 12% tax brackets. Those that qualify for this tax rate are single filers earning less than $38,600, head of household filers earning less than $51,700 and those who are married filing jointly making less than $77,200.
This strategy works for ‘lower income’ investors. Now, that doesn’t mean that the investor has a low net worth, it simply means that the investor doesn’t have a very high income for the year. The most obvious example of this is someone who is not working during the year. Two examples from my own client base are a retiree on Social Security and a graduate student.
If the latter had employed a tax gain and loss harvesting strategy prior to working with me, I could have helped them save tens of thousands of dollars on their tax burden. That client also faced another problem unique to tax loss harvesting. The fact that the stock market has been moving steadily upward since the beginning of the Obama Administration meant that there wasn’t much opportunity to harvest losses as the stock market rose.
Mind you, this strategy is more complex than tax loss harvesting, but it can be done by anyone. Obviously, working with a financial planning professional is the best way to ensure you follow the strategy correctly. That means that taking to many gains could create unintended consequences. If the amount of gains taken is too much, it can cause taxable income and impact the tax status of Social Security payments.
Coordinating your income and tax harvesting strategy is key to this gain harvesting. While capital gains may avoid taxation, they are still considered income. An investor needs to calculate their annual employment income, capital gain and dividend income, social security, and any other things that qualifies as income. This should be done near the end of the year in order to ensure an accurate amount is calculated.
Once you’ve calculated the amount of capital gains that you can take without crossing over the 0% long-term capital gain threshold, place an order for the sale of securities in that amount. After that, you can immediately buy the security back. Unlike a tax harvesting strategy, there is no wash sale rule that disallows the taking of a capital gain. That rule only applies to taking capital losses. By selling and purchasing back into the same investment, you’ve essentially reset the cost basis to zero without incurring any taxes.
Doing this on an annual basis could save you thousands of dollars. Keep in mind, however, doing this may incur additional state taxes. Also, the additional income from the gains could limit the use of available tax credits. Any potential increase these incur need to be compared against the potential savings. If you’re unsure about how best to structure a tax harvesting strategy, it’s recommended that you find a competent tax and financial advisor to help. The added cost could be worth the savings.