Reducing your current year’s tax bill is the top focus as the year end approaches. One approach many use to record a taxable loss is to sell some of the “losers” of their portfolio in an effort to reduce current year taxes. This is a great strategy, but we never look at the converse — what about creating capital gains?

How are capital gains taxed?

The tax code is filled with many complexities and capital gains are no different. Tax is calculated differently on capital gains because there are special tax brackets and income levels associated with this income. We will exclude all mention of short-term capital gains as you should never recognize short-term capital gains since they are taxed at your ordinary, higher tax bracket. Long-term capital gains and qualified dividends receive special treatment. The tax brackets range from 0% to 20% if you exclude the Net Investment Income Tax (which adds an additional 3.8% for extremely high investment gains). Below are the tax brackets based on income for the various filing statuses in 2018:

Filing StatusSingleHead of HouseholdMarried Filing Joint
0%$0 – $38,600$0 – $51,700$0 – $77,200
15%$38,000 – $425,800$51,700 – $452,400 $77,200 – $479,000
20%Over $425,800Over $452,400Over $479,000

As you can see from the chart, you are able to pay 0% tax on capital gains if your income is below a certain threshold based on your filing status. This presents an opportunity each year if your income falls into this range.

Tax gain harvesting

Tax gain harvesting makes sense for investors who have the ability to recognize income in the 0% capital gains tax bracket. A married couple would pay no tax on a capital gain of $10,000 if their income before the gain was $67,200. You can avoid paying taxes on the income in the future by recognizing the capital gain now. 

However, it is generally not advisable to recognize income at a 15% capital gain tax rate for the sake of reducing future taxes. You get the benefit of tax deferral when you let an asset grow with capital gains. This benefit almost always outpaces the benefit of reducing future taxes through capital gain income structuring for the 15% tax bracket and above.  Upon your death, you also get a step-up in basis on all of your taxable assets. This means that all assets that would not have been used during your lifetime get a free taxable gain if left untouched.

It is relatively simple to harvest a gain. In fact, there are less rules around it than tax loss harvesting. You simply sell an asset with a gain and you even have the option to buy it back the very next day. This increases your basis in the stock and you can now sell it in the future and pay less tax. Be cautious, though, as you are resetting the clock on the asset in terms of its favored long-term status if you sell then buy it back again. Make sure that you can get money from other assets in your portfolio so that you will not have to sell it later for a smaller short-term gain.

Tax loss harvesting

Tax loss harvesting makes sense for investors with short-term capital gains this year or those who can offset ordinary income with a capital loss. Offsetting ordinary income with capital losses is appealing because it reaps a larger tax benefit. However, offsetting long-term capital gains with capital losses will alway be the least beneficial use of the capital loss.

For example, let’s say you are in the 22% ordinary income tax bracket and the 15% capital gains tax bracket. $1,000 of a net capital loss saves you $220 in income taxes. However, offsetting $1,000 of capital gains with capital losses only saves you $150. Saving your capital losses to be used to offset ordinary income can create a larger tax benefit for you.

There are a few rules for tax loss harvesting that you need to know about. First, you cannot sell an asset that has a loss then buy it back again within 30 days. This will result in the loss being disallowed on your tax return. Second, each year you are only allowed to deduct $3,000 of capital losses against ordinary income. The unused losses carryforward to the following year, but this means that losses in excess of $3,000 are less useful as you will see no tax benefit until you recognize more capital gains or more years pass.

Capital gains and Social Security

The recognition of capital gains and losses affects how your Social Security is taxed. However, since capital gains are taxed at lower rates (even 0%!), it may make sense to create capital gains instead of ordinary income during the Social Security taxability range. Social Security effectively doubles your tax bracket by recognizing $0.85 of income for every dollar of other taxable income you recognize.

If your ordinary tax bracket is 12% and your capital gains tax bracket is 0%, then every dollar of capital gains income will only cost you 10% in tax as your Social Security gets taxed. This contrasts to the alternative of 22% if you created income using your Traditional IRA or other ordinary income means.

Conclusion

There are a lot of moving parts to consider when recognizing gains or losses in your taxable accounts. However, you can take advantage of the tax structures and pay the least amount of tax over your lifetime using these practices. Set up a time to talk with us if you would like to explore how tax gain and loss harvesting can benefit you.

Written by Garrett Gould

Garrett Gould is a remote financial planner who specializes in long-term tax management. He is the co-owner of Halyard Financial and advises individuals, families, and small business owners throughout the nation. Garrett is an Enrolled Agent with the IRS who has passed all three of the CFA exams and has been creating financial plans for several years. Garrett is located on the Upper West Side in New York City.