Many investors and financial advisors now employ a tax management strategy known as tax-loss selling or harvesting losses. Alternatively, some investors could also take advantage of harvesting gains but many of them don’t. I find this is usually because they don’t know about it or think they wouldn’t qualify for a 0% capital gains tax.
Harvesting Losses Revisited
Harvesting losses simply means reviewing the investments that have in a taxable investment account (not IRA’s or other retirement accounts), selling those that show a loss and reinvesting the proceeds. As long as a wash sale is avoided, the loss can be used to lower taxes by offsetting profits made on another investment. And if you find yourself with more losses than you have profits, you can save the unused losses to use against future profits. Done consistently and over time, this strategy can substantially reduce investment related taxes. I wrote more about this strategy here.
Fortunately, the investment gods have been smiling on us for the past several years resulting in few opportunities to harvest losses. The upshot is that many investors have exhausted their unused losses and will now be looking at a large tax bill when they do sell a profitable investment. However, there is a lesser known strategy, harvesting investment gains, available to some individuals where they can take a profit on an investment and pay no taxes.
Harvesting Investment Gains
Harvesting investment gains is just like it sounds, selling securities where you have a profit. Most people automatically assume they will pay some tax on the gain and so try to avoid doing this until they have to. However, for those of you in the 2 lowest tax brackets, it may make sense to use this strategy as you could avoid paying current or future taxes on some or all of your investment income and profits.
Now, like most people I speak with about this strategy, right now you’re thinking you don’t qualify because your income is too high. If you’re working full-time, that’s probably true. However, if you’re retired, you may be pleasantly surprised. And even if you don’t qualify you may still benefit indirectly if you normally make cash gifts to your adult children or grandchildren.
Do You Qualify?
If you’re a married couple and your taxable income is less than $75,900, you may be able to make use of this strategy. Note that taxable income is not the same as gross or adjusted gross income. It’s what’s left after all adjustments, deductions and exemptions are accounted for. If you don’t itemize deductions, then between your standard deduction ($12,700) and personal exemptions ($4,050 each) you would reduce your gross income by $20,800 to get your taxable income. So that means if your gross income was lower than $96,700, some portion of your investment income and capital gains would not be taxed. For single filers, the amount would be half, or $48,350.
Before going any further now is as good a time as any for the usual disclaimer. Nothing stated in this article (or anywhere else on this website) should be construed as tax advice. Your situation is different from anyone else who reads this and almost certainly is not exactly the same as any of the scenarios I discuss. In other words, before taking any action that could have tax consequences, consult with your personal tax pro.
So lets look at an example. John and Mary Smith are both 66. Between the taxable portion of their social security, John’s small pension and Mary’s part-time job, they have a total of $60,000 in income. They also have savings in a taxable investment account and IRA accounts. They don’t want to pull any money from their IRA’s until they have to (70.5) so they take money from their taxable account when needed. Their taxable investment account is worth $500,000 including $100,000 worth of Apple stock that Mary bought 12 years ago for $5,000. The investments in the account generate $8,000 per year in dividends. Their IRA’s total $600,000.
They’re happy the Apple stock has done so well but they would like to reduce the amount they own in a tax efficient manner. So let’s see how much they can harvest in gains each year from their without having to pay tax on those profits. They have a simple return, each getting a $4,050 personal exemption ($9,100 total) and taking the $12,700 standard deduction for a total of $20,800 in deductions and exemptions. This means their total taxable income is $39,200 ($60,000 – $20,800). Since capital gains taxes are 0% until taxable income gets above $75,900, they can generate a total of $36,700 in capital gains and dividend income without having to pay capital gains taxes ($75,900 – $39,200). As they have $8,000 in dividend income, they could generate another $28,700 in capital gains from the sale of Apple stock without paying any additional taxes.
If they followed this strategy for the next 4 years, John and Mary would be able to sell all their Apple stock without paying any tax on the $95,000 gain!
Who is Most Likely to Benefit?
People who are retired but not yet taking required distributions (RMD’s) and/or social security are usually in the best position to make use of this strategy as their taxable income may be low enough to allow for harvesting a substantial amount of capital gains each year. Once RMD’s begin, along with Social Security and other income sources, taxable income may exceed the 15% tax bracket. At that point, capital gains are taxed at 15%. In the John and Mary example above, once they hit 70.5 and begin taking RMD’s from their IRA’s, they will have over $20,000 in additional taxable income. This will lower the amount of capital gains they can harvest by an equivalent amount.
Another case where harvesting gains may be available is when there is a significant disruption to household income, say from an extended period of unemployment or going back to school. In this case taxable income may fall low enough to allow some gains harvesting.
And, as I alluded to earlier, you may also be able to benefit from this if you make gifts to adult children or grandchildren. If their income is low enough for them to harvest gains, consider gifting them appreciated stock instead of cash.
The wash sale rule does not apply to buying back securities sold for a gain. In the John and Mary example, if they wanted to keep the same amount of Apple stock but still reduce their tax liability, they could sell enough shares to harvest the gain and then immediately buy those shares back. They will have increased their cost basis and were only out of the stock for a few seconds, the amount of time it took them to place the sell and buy trades.
Note that any gains you harvest are counted as income for determining when the 15% capital gains tax rate kicks in. Every now and then someone misunderstands the strategy and thinks they can harvest an unlimited amount of gains if their other income is low enough.
The 0% tax rate only applies to federal capital gains taxes. Many states, including Virginia, still charge state income tax on any amount of capital gains.
While this can be an effective strategy, other tax planning strategies such as partial Roth conversions may be more advantageous.
The tax code is complex. Increasing taxable income by harvesting gains may have other unintended consequences such as increasing the amount of Social Security subject to taxes, loss of health insurance subsidies, or loss of other deductions based on income.
And depending on what happens with tax reform that’s currently going through Congress, this strategy may change for 2018 and beyond. Stay tuned.