Tax-gain harvesting may seem counter-intuitive, but it can be an effective way to reduce your total tax burden in retirement.
Mindful tax planning is one of the easiest ways to improve your finances in retirement. What makes that true is the fact that current tax rates are known, so any time you make a decision that has an immediate tax effect you know precisely what the immediate outcome will be.
However, a key element of good tax planning in retirement is to consider your taxes over the long-term. Don’t just look at your tax bill one year at a time. That type of analysis can be short-sighted and doesn’t always give you the best long-term tax results. Sometimes it makes sense to increase your tax bill now to reduce it even more later.
Tax-gain harvesting is one tool you have for doing that.
What is Tax-Gain Harvesting?
Tax-gain harvesting is not the same thing as the more popular tax-loss harvesting. A quick refresher on tax-loss harvesting in case you can’t recall…
When you sell stocks or mutual funds for more than you bought them for you have a capital gain. You will have to pay taxes on that capital gain. When you sell shares at a loss (for a capital loss), you can use that loss to offset capital gains for tax purposes.
A simple example:
You invested $100,000 in mutual fund A and another $100,000 in mutual fund B. Mutual fund A is now worth $125,000 and mutual fund B is now worth $75,000.
If you sell mutual fund A you will have a $25,000 capital gain, and you will be taxed on it.
You can sell mutual fund B for a $25,000 loss which will offset the gain on A and you won’t owe any taxes.
The capital gain is entirely offset by the capital loss.
Harvesting the capital loss lets you avoid paying taxes on the capital gain. This is the scenario you likely envision when you think about harvesting capital gains and losses.
Tax-Gain Harvesting
Tax-gain harvesting is the opposite of tax-loss harvesting. With this strategy you intentionally sell shares in order to realize capital gains.
Won’t that drive up my tax bill? Why would you do that?
Yes, it will increase your tax bill for this year. If you do it correctly though it will reduce your tax bill even more in a later year. You harvest capital gains so that you can control your tax bill. You decide when to sell the shares, so decide to sell them when it’s most beneficial to you. Remember, the idea is to think about your total tax burden over your entire retirement, not just for this year, and reduce your average effective rate.
Wash-Sale Rule
Before we discuss the strategies for harvesting capital gains, I think it’s important to point something out now. If I don’t, you may wonder about it as you read and get distracted. Let’s talk about the wash-sale rule. If you know anything about taxable gains and losses from investments then you know about the wash-sale rule.
When you harvest capital losses, the wash-sale rules says you can’t immediately buy the shares back. If you do, the loss is disallowed for tax purposes. In other words, you won’t be able to use it to offset capital gains and avoid paying taxes.
The particulars of the wash-sale rule aren’t important here. What you need to know about the wash-sale rule for tax-gain harvesting is simply that it doesn’t apply.
That’s useful to know because when we harvest capital gains, we don’t always want to hold the cash. We can immediately repurchase the shares and be right back where we started, minus the unrealized capital gain and future tax liability.
That really makes sense if you think about why the wash-sale rule exists in the first place. The rule is in place to keep you from avoiding taxes with quick transactions that let you realize capital losses. But we are going the other direction here. The IRS isn’t going to prevent you from doing something that increases your tax bill.
So when is it most beneficial for you to cause a tax increase for yourself?
You Are In a Low Marginal Tax-Bracket
A good time to harvest capital gains is if you are in a lower marginal tax bracket now than you will be later. Harvesting your capital gains in a year you are in a lower marginal tax bracket can reduce the amount you owe in later years. There are several reasons this might be the case. I’ll discuss a few common ones here.
You Haven’t Started RMDs
For example, it could be that you aren’t yet taking withdrawals from an IRA. Once RMDs start that extra withdrawal will increase your taxable income. If that withdrawal is going to push you into the next tax bracket it may make sense to go ahead and realize your capital gains and pay the capital gains tax while you are still in a lower bracket.
You may have to sell the shares later anyway, so go ahead and do it now while your tax rate is lower. Simply reinvest the money if you don’t need the cash right now. If you repurchase the shares, your basis will be the new purchase price. Any gains going forward will be based on that. You won’t be in any different positions, but you won’t have unrealized gains as a looming tax liability.
You Haven’t Started Receiving Social Security
If you haven’t’ started receiving your Social Security retirement benefits yet it may be a good idea to go ahead and realize some gains.
If you have capital gains that you can harvest before you start receiving Social Security benefits you won’t have to include the gain in your AGI. If you wait and instead sell the sell the shares later, the gain will be included in your AGI and could increase the taxable amount of your Social Security benefit.
Matching Capital Gains and Losses
If you sold investments at a capital loss at some point during the year you can use that loss to offset gains. However, you have to actually have realized the gains to offset them. Tax-gain harvesting is exactly that.
This seems like the classic case of tax-loss harvesting, but it isn’t. The steps are in reverse order here. We are harvesting capital gains because we have previously incurred a loss.
Again, realize here that the wash-sale rule would apply only to the shares you sold at a loss. We are focusing on the shares you sell for a gain. You can immediately repurchase the shares you sell for a gain and still take advantage of the capital losses.
