An opportunity that should never be passed up by an investor is the ability to convert a taxable long-term capital gain into tax-free basis without paying taxes to do so.
This is known as harvesting long term capital gains. It’s a process of intentionally selling an investment with a taxable long-term capital gain, in years when that gain will not be taxed, and then buying it back immediately.
The gain won’t be taxed when it occurs in a year when the investor is in the “0” long term capital gain tax bracket, which for 2021 occurs when they have taxable income of $40,400 or less for singles, or $80,800 or less for married couples.
The genius of doing this is that it increases the amount of the investment that shows as the original amount invested, better known as “cost basis”, which is always tax free, by the amount of the realized capital gain that was taxed at zero.
Remember, because the cost basis in an investment is tax-free, the more you have, the less capital gains tax you pay later when you really want to sell the investment if you end up in a higher tax bracket.
And many people will end up in a higher tax bracket due to things like pay raises, starting Social Security or pension benefits after retirement, or taking required minimum distributions at age 72.
Even if your taxable income is normally too high to harvest gains with zero tax, there may be some years where you can take advantage of this strategy, such as when you are:
- Temporarily unemployed.
- A self-employed person and your income varies from year to year.
- Between the ages of 60 and 72 and retired.
Also you can sometimes intentionally create a low tax year that qualifies for gain harvesting by delaying a bonus until next year, waiting to take taxable distributions out of retirement accounts until you’re required to do so at age 72 or even later if you’re still working, and/or delaying your Social Security benefits until age 70.
For example, let's say you're married, you just retired, and your taxable income for the year is going to be $50,000.
Remember, the first $80,000 of your taxable income is taxed at a “0” long-term capital gain tax rate. Therefore you have $30,000 of long-term capital gain you can trigger without going over the $80,000 threshold and a “0 “capital gain tax rate will apply. In other words, you can trigger this gain tax-free.
If you own stocks or mutual funds in a taxable account and some of your positions have unrealized long-term capital gains, you have a tax planning opportunity.
You can sell enough of your investments to trigger $30,000 of long-term capital gain and pay no income tax on it.
And, assuming you want to keep these investments, you could buy them back “immediately”, with the $30,000 of taxable long term capital gains eliminated forever, with no tax consequences, when you go to sell the investments later.
You do not have to wait 31 days to buy the investments back to abide by what is known as the wash rule, which only applies to taking capital losses, not capital gains.
Before you use this strategy be sure to check to see if you have any capital gains distributions that may pay out on mutual funds that you own in taxable accounts.
Mutual funds distribute capital gains in the fall of each year, and some funds distribute these funds as late as mid-December. These are gains that can be triggered even if you have not personally sold any of the mutual fund shares.
You’ll want to know what these gains are before you decide to intentionally realize additional gains. Otherwise, you could get thrown into a higher long-term capital gain tax bracket which will be at least 15%, and end up paying tax on part of the gain.
Also, remember capital gains taxed in the zero tax bracket are still income and will therefore increase your adjusted gross income, which could potentially increase your taxes in other areas.
For example it could result in reducing or disallowing the medical expense deduction if you itemize or trigger the taxation of otherwise nontaxable Social Security benefits.
So while you have to do your homework to avoid some of these tax landmines, the fact remains that strategically harvesting gains in low-income tax years, may reduce your tax liability and put more income in your pocket.
The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.