Earlier we had a brief discussion on tax loss harvesting. For those that missed the previous article, tax loss harvesting is a technique where you generate paper losses in your taxable account by swapping out losers with highly correlated (but not substantially identical) index funds or other securities. You can deduct up to $3,000 of net investment losses per year from your ordinary income today (and therefore save on your tax bill at your marginal rate) while delaying an eventual tax at capital gains rates until sometime in the future. In other words, saving at close to 40% today and paying taxes at around 15% in the future.
Many investors don’t realize that there’s also an appropriate time to take on some tax gain harvesting.
Harvesting Your Gains
Harvesting your taxable gains is a relatively straightforward process. Let’s say you have an investment account with $10,000 in VTSAX, of which $5,000 is the original investment and $5,000 is locked in capital appreciation.
Step 1) Sell the investment in your taxable account and receive $10,000 in cash.
Step 2) Immediately repurchase the same index fund for $10,000.
What you’ve now done is generated a $5,000 capital gain on your balance sheet and increased the cost basis of your investment from $5,000 to $10,000. When you sell the investment in the future, you will only be taxed on the gains above $10,000.
Of course, most of you are probably more focused on the fact that we’ve just generated $5,000 in capital gains. For a typical lawyer, that means you’ll be paying 15% or 20% of tax on the gains during this year’s tax bill. Not exactly a good situation, since around here we believe that a tax delayed is a tax not paid.
You’re in a year with low income. Perhaps you’ve decided to transition out of Biglaw and are taking a 1 year sabbatical between jobs. Or perhaps you’ve decided to leave the workforce to work at a startup where you expect low cash compensation. Or, unfortunately, maybe you’re dealing with an illness or are otherwise sidelined. The point is that there are some years where you may see a huge drop in income or have no income at all.
During those low-income years, you may be able to take advantage of the of the 0% capital gains tax rate.
Let’s explore an example. In 2016, a married couple can shield up to $20,700 in earned income from taxes ($10,350 if you’re single). That’s because of the $12,600 standard deduction for married couples and the $4,050 per person personal exemption. From there, you could theoretically increase the deductions further by making $18,000 401(k) contributions for each person. That’s up to $56,700 in earned income for a married couple that is completely tax free. After you’ve shielded the income through retirement accounts, the standard deduction and personal exemptions, you have up to $75,300 of your adjusted gross income to work with before you bump up into the 25% tax bracket (and therefore have to pay 15% towards capital gains).
If you sell $75,000 of investment gains in a taxable account and immediately repurchase the same security, you’ll generate $75,000 of income which will be taxed at a 0% capital gains rate. The benefit is that you’ve now reset your cost basis in the investment upwards of $75,000. When you sell the investment in the future you’ll only have to pay taxes on the gains between the selling price and the upward adjusted capital gains.
Would I want my accountant to eyeball this before I executed the plan? You bet. Am I confident that others are doing exactly this? No doubt.
While the situation may not apply to many people, I hope I’ve planted the seed in your mind that in a low income year there may be steps you can take to maximize your tax situation. I know of many lawyers who take some time off after leaving Biglaw and that would be a great time to harvest some gains. The same is true for anyone who might be in a transition stage of life.
1) Pushing Your Income to 25% Bracket. Be careful that you don’t sell too many funds such that you generate income that pushes your income into the 25% bracket. In other words, when you sell investments, the capital gains are treated as income for purposes of calculating where you fall in the standard tax brackets. The gains themselves are taxed at capital gain rates but if you liquidate $100,000 worth of capital gains, you will be in the 25% tax bracket which means your capital gains will be taxed at 15%, thus defeating the purpose. Read more about how an early retiree is liquidating capital gains while staying in the 0% bracket: Never Pay Taxes Again.
2) Vanguard Funds. There’s a catch if you are thinking about tax gain harvesting Vanguard mutual funds.
From their website:
If you sell or exchange shares of a Vanguard fund, you will not be permitted to buy or exchange back into the same fund, in the same account, within 60 calendar days.
This is to discourage frequent trading. It does not apply to ETFs, nor does it apply to orders by mail, future investments made by automatic purchase or if you sell a fund and purchase a similar fund (e.g. selling VTSAX and then immediately purchasing VFIAX). In short, there’s plenty of ways around it, but you should call Vanguard and talk to a representative if you have any questions about their policy.
3) Short-Term Capital Gains. This doesn’t apply to short term capital gains. Those will be taxed at your ordinary income rate, so make sure you’re selling investments that you’ve held for over a year.
4) Wash Sale Rule. You may remember from tax loss harvesting that there are rules prohibiting you from purchasing substantially identical investments after selling an investment for a loss. The wash sale rules don’t apply when selling an investment for a gain. Since selling the investment for a gain is a taxable event (just happens to be 0% in our example), the IRS is happy to let you do this all day long.
5) Offsetting Tax Loss Harvesting. If you’re carrying forward the maximum $3,000 long term capital losses from previous tax loss harvesting, your long term capital gains are going to offset those previous losses. This would also sort of defeat the purpose since you’re just shifting around the cost basis between two investments. You want to use your long term capital losses to offset your ordinary income (which means not having an long term capital gains in the same year) to truly take advantage of tax loss harvesting.
Let’s talk about it. Can you see yourself in a situation where you have low income for a year? If so, would you take advantage of tax gain harvesting?
Joshua Holt A practicing private equity M&A lawyer and the creator of Biglaw Investor, Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.