Deservedly, tax-loss harvesting receives a lot of attention when it comes to tax planning strategies. The idea is relatively simple on the surface – obtain a tax benefit from the sale of securities that have declined in value since purchase. It is an effective tool for taxpayers with sufficient realized capital gains to offset.
Consider the following example:
- Earlier this year, Taxpayer sold Stock X, realizing a short-term capital gain of $8,000.
- Taxpayer currently owns Stock Y with an unrealized loss of $5,000 purchased in 2018 and Stock Z with an unrealized loss of $3,000 purchased two months ago.
Assuming the highest tax bracket, the sale of Stock X results in tax of $3,264 ($8,000 * 40.8%). Taxpayer decides to harvest losses to offset the short-term capital gain by selling Stock Y and Stock Z. The $8,000 short-term capital gain is offset by the realized losses of Stock Y ($5,000) and Stock Z ($3,000) resulting in no tax on the sales. The taxpayer then invests the proceeds of the sales in securities that are not considered “substantially identical” by the IRS to avoid the wash sale rule. A wash sale occurs if a taxpayer sells a stock or security at a loss and within 30 days before or after the sale, directly or indirectly buys, acquires, or enters into a contract or option to acquire substantially identical stock or securities.
Tax-loss harvesting can be more beneficial for taxpayers in higher brackets. The higher the bracket, the greater the tax savings.
Discussed less frequently is tax-gain harvesting – selling investments that have appreciated in value since purchase. The goal is to take advantage of lower tax brackets by selling an investment when it will have little or no impact on taxes. If you want to keep the investment, there are no tax restrictions on buying it again after the sale. The wash sale rule applies to losses. Although this post is written from a tax-driven strategy, tax-gain harvesting mixes nicely with a buy-low/sell-high investment strategy.
For 2023, taxpayers with taxable income below $44,625 ($89,250 MFJ, $59,750 HOH) pay no tax on long-term capital gains (LTCG) and qualified dividends. Short-term capital gains continue to be taxed at ordinary income rates. For example (Examples 1 and 2), a single taxpayer with taxable income of $30,000 (after deductions) could realize up to $14,625 of LTCG without crossing the $44,625 threshold of the 0% LTCG tax bracket. By buying back the investment, the cost basis is reset. Any LTCG over $14,625 is taxed at the higher rates (15% and 20%) (see Example 3).
It’s important to keep in mind other tax strategies, such as a Roth IRA conversion. Ordinary income fills the lower brackets first with capital gains stacking on top. Building on the prior examples, the taxpayer converts $15,000 of a traditional IRA to a Roth IRA. Ordinary income increases by $15,000 bringing taxable income up to $45,000. The taxpayer is now over the $44,625 threshold. Any LTCG will no longer receive the benefit of the 0% bracket (see Examples 4 and 5).
The 15% bracket for LTCG rates for single taxpayers in 2023 applies to taxable income levels of $44,626 to $492,300 ($89,251-553,850 MFJ, $59,751-523,050 HOH, $44,626-276,900 MFS). The 20% bracket applies to LTCG above those amounts. See Examples 6 and 7.
Tax-gain harvesting works well in years where taxpayers expect income to be lower. Maybe it’s a year between jobs or after retirement but before required minimum distributions begin. The capital gain recognized still counts as income even if it’s included in the 0% bracket. The increase can impact tax deductions such as IRA contributions and medical expenses, as well as the phaseout of credits such as education credits. As always, tax planning involves an all-encompassing approach factoring in the impact each has on its counterparts.
