Accelerate deductions. Defer income and gains.
Those are the two main rules of the road for reducing your tax bill: Both are geared toward reducing taxes in the current year, and deferring income and gains kicks your tax bills into the future. In other words, you get to have access to more of your money for a longer period of time, which is the name of the game for tax management.
But thanks to the existence of a 0% tax rate on long-term capital gains for the lowest-income investors, accelerating gains by pre-emptively selling winning securities can make sense in some situations. By realizing gains on those holdings, you reduce the tax liabilities associated with those positions. Even if you re-buy the same stock, fund, or ETF shortly after selling, the act of purchasing at today's higher prices will reduce any gains that are eventually due. If the market tanks after re-buying, you may be able to take tax losses on those holdings. Moreover, such gain harvesting can enable you to improve your portfolio.
Who Should Give the Strategy a Look
Before we go any further, it's important to note that tax-gain harvesting won't be of use to many--even most--investors. Specifically, an individual must have both low taxable income and high levels of taxable holdings (nonretirement accounts) to benefit from tax-gain harvesting in a meaningful way.
First, the income limitations: In order to qualify for the 0% tax rate currently in place for long-term capital gains, you must be a single filer with taxable income of $38,600 or a joint filer with taxable income of $77,200 in 2018. It's important to point out that those income thresholds are inclusive of any capital gains you've realized during the year. In other words, realizing capital gains will jack up your taxable income, so just because your ordinary income falls under the threshold for 0% tax on long-term capital gains, you're not able to realize an unlimited amount of capital gains at a 0% rate.
To use a simple example, let's say that Felicia, single and a new retiree, took withdrawals from her traditional IRA that amounted to $30,000 in 2018. She could then realize another $8,600 in capital gains by withdrawing highly appreciated longtime holdings from her taxable accounts while maintaining eligibility for the 0% capital gains rate. If she realized $20,000 in long-term capital gains, the first $8,600 would be eligible for the 0% rate but the additional $11,400 in gains would be subject to the 15% tax rate. (This article from Michael Kitces discusses the interplay between income, deductions, capital gains, and the 0% long-term capital gains rate.)
Additionally, only assets sold from taxable accounts are eligible for long-term capital gains rates. Thus, tax-gain harvesting is only useful insofar as it relates to taxable holdings. No amount of fancy footwork can reduce the tax bills that are due on withdrawals from tax-deferred accounts like 401(k)s and IRAs. The money you pull from those accounts, save for your own contributions, is taxed as ordinary income and that's that.
How It Can Be Useful
Yet even though tax-gain harvesting may only be useful to a small subset of investors, it's still worth a look, especially from investors who find themselves in a low tax year temporarily. That includes newly retired investors who have little taxable income today but expect to see their income spike when required minimum distributions kick in, or people who were unemployed or underemployed for much of the year.
First, there's a potential tax benefit. By selling appreciated securities that have been in a taxable portfolio for at least a year, an investor in the 0% bracket can reduce those holdings--up to the taxable income thresholds of $38,600 for single filers and $77,200 for married couples filing jointly, including other income--without owing taxes on the gains.
To use a simple example, let's say Jack made a $10,000 investment in Vanguard Total Stock Market Index (VTSMX) at the beginning of 2010. Today, his position is now worth more than $29,000. Assuming his total income stays under the 0% threshold for capital gains (and again, that's a big assumption, because that's a low level of all-in income), he could sell the position to essentially wash out his $19,000 profit, with no federal tax cost to him. He could then re-buy the same fund at today's current, higher price. (In contrast with tax-loss selling, no wash-sale rules govern tax-gain harvesting; you don't have to wait 30 days to re-buy the same security.)
Now let's assume that Jack is in a higher income-tax bracket five years in the future, and he now owes capital gains taxes at a 15% rate. If he needs to sell his Vanguard Total Stock Market Index position, the fact that he stepped up his cost basis in 2018 would reduce the taxes due at the time of sale. If his position had increased to $36,000, he'd owe capital gains on that $7,000 in new appreciation (the difference between his $29,000 purchase price and $36,000 sale price), or $1,050 in taxes, assuming he sold all of his shares. Had he not stepped up his basis in 2018, the tax hit would be calculated the spread between his initial cost basis ($10,000) and the price of his stake at time of sale ($36,000). His total tax tab would be $3,900--based on his 15% long-term capital gains rate and the $26,000 in appreciation over his holding period. If the position declined in value after he re-bought it, he could take a tax loss on the difference between his purchase price and his lower sale price.
Those examples assume that Jack wants to use tax-gain harvesting but maintain a position in the fund. But tax-gain harvesting can also be effective for positions an investor would rather sell. Rebalancing--trimming appreciated positions and deploying the money into holdings that have declined or appreciated less--can prompt a tax bill within a taxable account. But investors who can stay under the 0% threshold for capital gains can rebalance without tax consequences. Ditto for investors who own a position that is fundamentally problematic or simply too large for their portfolios. In that instance, tax-gain harvesting gives them a chance to reduce their positions in problematic holdings without tax consequence.
Not Just for 0% Capital Gains
Finally, it's worth noting that the type of tax-gain harvesting discussed above can be a good fit for investors who expect to be in a higher tax bracket in the future than they are today--even if they're not in the 0% tax bracket. For example, let's say an investor knows for certain that she'll be in the 20% long-term capital gains bracket next year, but for 2018 will be in the 15% bracket. In that instance, it can make sense to pre-emptively realize gains, for all of the same reasons outlined above. Because there are so many moving parts involved with such a decision--income and capital gains taxes, deductions, and investment merits--check with a financial or tax advisor before proceeding further.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.