A few months ago, we discussed saving on taxes via tax-loss harvesting. As a refresher, the idea of tax-loss harvesting is to:
- Sell an investment with a current value that’s lower than your cost basis in the investment (so that you can claim the tax loss), and
- Buy a similar (though not “substantially identical”) investment at the same time so as to not dramatically throw off your asset allocation.
But sometimes it can make sense to do the opposite: harvest your capital gains.
Specifically, if your current tax rate for capital gains is significantly lower than what you expect it to be in the future, it can sometimes make sense to:
- Sell an investment with a market value that’s greater than your cost basis in the investment (and pay any applicable capital gains tax now, at your lower tax rate), and
- Use the proceeds to buy a similar investment so you don’t mess up your asset allocation.
Are You in the 10% or 15% Tax Bracket?
For investors in the 10% or 15% tax brackets, the tax rate on long-term capital gains is currently 0%, which can make tax-gain harvesting particularly advantageous.
Example: For this year, Diane is in the 10% income tax bracket. Therefore, under current tax law, her tax rate on long-term capital gains is 0%. Diane expects, however, to move into the 25% tax bracket next year as a result of a job she’ll be starting this fall — meaning that her tax rate on long-term capital gains will be higher than 0% in the future.
Aside from the investments Diane owns in her IRAs, Diane’s only holding is $4,000 in Vanguard Total Stock Market ETF, which she has held for more than one year. Her cost basis in the ETF is $3,000. She can sell the ETF and claim a $1,000 long-term capital gain, on which she’ll pay $0 in taxes. Then she can buy a similar mutual fund or ETF for $4,000. As a result, her cost basis in the new investment will be $4,000 rather than $3,000, meaning her capital gain will be smaller when she eventually sells it in the future.
It’s important to note, however, that if an investor harvested too large of a gain, the gain itself could push her into a higher tax bracket, thereby meaning part of the gain would no longer qualify for the 0% tax rate.
Capital Gain Tax Rates Scheduled to Increase
As of right now, the 15% maximum tax rate on long-term capital gains is scheduled to increase to 20% at the beginning of next year. That could make this year a good time for tax-gain harvesting, even for people who, unlike Diane in our example above, would have to pay some taxes on their capital gains.
Personally, however, I would hold off on taking such actions just yet. There’s a good chance that Congress will vote to extend the 15% tax rate for long-term capital gains, in which case the only result of tax-gain harvesting would be that you’d have to pay taxes now rather than later, which, all else being equal, is not a good thing.
That said, there are some possible exceptions:
- Due to the new 3.8% tax on investment income (including capital gains) for investors with adjusted gross incomes above $200,000 ($250,000 if married filing jointly) that will begin in 2013 as a result of the Affordable Care Act, it may make sense for high income investors to harvest tax gains this year, even if the 15% rate does get extended, and
- It may make sense to get the ball rolling for any not-super-liquid investments that you hope to sell. For example, if you planned to sell a piece of rental real estate to harvest a tax gain, you wouldn’t want to wait until the last week of December to put the house on the market.
In addition, it would probably not be a bad idea to put a reminder in your calendar for, say, December 15 to check whether any such legislative action has in fact been taken.