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. I 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 2020:
|Filing Status||Single||Head of Household||Married Filing Joint|
|0%||$0 – $40,000||$0 – $53,600||$0 – $80,000|
|15%||$40,000 – $441,450||$53,600 – $469,050||$80,000 – $496,600|
|20%||Over $441,450||Over $469,050||Over $496,600|
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 or if we can get your income into this range by using the Income Roller Coaster Method
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 $70,000. 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. We only want to harvest gains at the 0% rate typically. 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 taxable gain. In fact, there are fewer rules around it than tax-loss harvesting. You simply sell an asset with a taxable 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 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 always be the least beneficial use of a capital loss. If we can choose to pay tax on long-term capital gains one year – then take the $3,000 capital loss offset to ordinary income the next – we will be able to save you MORE in taxes than offsetting those favorable long-term gains.
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. The loss is disallowed if you do. Second, each year you are only allowed to deduct $3,000 of capital losses against ordinary income. The unused losses carry forward 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.
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 life using these practices. Advisors far too often focus on minimizing current taxes which comes at the expense of a greater future tax bill. Set up a time to talk with us if you would like to explore how tax gain and loss harvesting can benefit you.