Tax Gain Harvesting: What is It and When to Use It
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm continuing with our year-end tax planning content by talking about tax gain harvesting.

While tax loss harvesting typically gets all the attention, realizing gains and deliberately paying taxes now can oftentimes be more valuable. And once again, this strategy is not just for the ultra rich. In fact, those people that are in the highest tax brackets probably shouldn't pursue this tax planning opportunity.

So if you want to learn how to harvest gains and reduce your future tax bill in retirement, today's episode is for you. For all the links and resources mentioned, head over to youstaywealthy.com forward slash 90.

For many investors, the benefit of tax loss harvesting is overestimated. As harvesting a loss generates current tax savings, it also reduces the cost basis of the investment, triggering a potential gain in the future that may offset most or even all of the loss harvesting benefit.

That's a quote pulled from a great article written by Michael Kitsis on the true benefits of tax loss harvesting, which I'll link to in the show notes. But as mentioned at the top of the show, tax loss harvesting seems to get all the attention.

For the last 14 years or so of my career, I can probably count on one hand how many times I've heard someone talk about tax gain harvesting, which can often be much more impactful. So I want to do my part today to make sure that everyone is aware of this little known strategy, especially those that are in their gap years, which I previously shared is the sweet spot for your tax planning in retirement.

As a reminder, your gap years are the years from the date you retire until age 72, which is when required minimum distributions or RMDs kick in. These are the years which your income is likely at its lowest point, allowing you to do some pretty awesome tax planning that can save you hundreds of thousands of dollars over your lifetime, and in some cases, millions of dollars, depending on your situation.

And these are the people that I do my best work with, retirement savers over age 50 who are retired or approaching retirement and not only want to create reliable income in retirement, but also want to reduce their lifetime tax bill.

Just a quick side note, if you're ever interested in evaluating my firm, just a quick reminder that we offer a free retirement checkup, which includes a tax analysis. So you can see exactly how we can help you before ever deciding to hire us. There are no strings attached here. Just go to definefinancial.com and click on the magenta purplish button on the homepage. You can't miss it.

And before I go any further, I want to emphasize that I'll be sharing a lot of numbers and hypothetical scenarios today regarding taxes and investments and tax planning. This is just for information and educational purposes only. It is not advice. Please, please, please talk to your trusted advisors, your financial advisor, and your tax professional before ever taking action.

Okay, so the first thing to know before we get into the details of capital gains harvesting is that long-term capital gains have their own tax bracket, which is separate from your ordinary income tax bracket.

In fact, there are four long-term capital gains tax brackets. And to keep things simple, I'm just going to share the four capital gains tax brackets for a married couple who's filing jointly. If that's not you, I'll link to the other tax tables in the show notes so that you can take a look. So if you're married filing jointly, here are the four long-term capital gains tax brackets in 2020.

0% capital gains rate is applied if taxable income is between $0 and $80,000. 15% capital gains rate applies if income is between $80,000 and $250,000. If your income is between $250,000 and $496,000, you're going to pay a long-term capital gains rate of 18.8%.

And if you've got taxable income higher than $496,000, you're going to be paying the maximum long-term capital gains rate of 23.8%. So those are the four long-term capital gains tax brackets in 2020. As you might've guessed, those last two tax brackets, 18.8% and 23.8% are a result of the Medicare surtax of 3.8%, which was part of the Affordable Care Act of 2010. So

So again, for long-term capital gains tax bracket, tax brackets, 0%, 15%, 18.8% and 23.8%.

Really quick, I just want to highlight and emphasize one more time that we're talking about long-term capital gains here, which applies to securities held longer than 12 months. If you have an investment that's gone up in value and you've held it for less than 12 months, that would be considered short-term and short-term capital gains are taxed at ordinary income. So for the sake of today's conversation, just know that we're only talking about positions that you've held for longer than a year.

So going back to the tax rates on long-term capital gains, if a married couple filing jointly has taxable income between zero and $80,000 in 2020, they're going to qualify for 0% tax on long-term capital gains.

And if you're in your gap years and you have most of your investments in qualified retirement accounts like IRAs and 401ks, and you've delayed social security to age 70, it's very likely that your taxable income is going to be less than $80,000. So here's a hypothetical example to show you how this strategy might work in action.

Tom and Linda retired at age 60 and they're living off of a $50,000 per year pension plus just some cash savings that they have in the bank while they wait for social security to kick in.

They're going to get the standard deduction of $24,800, which means after that deduction, their ordinary income is going to drop to $25,200. This puts them in the 12% ordinary income tax bracket, and it also puts them in the 0% capital gains bracket with just under $55,000 of wiggle room left until they're taxed at 15% on long-term capital gains.

This means that Tom and Linda could realize just under $55,000 in long-term capital gains at a 0% rate.

Which is great because Tom bought $10,000 of Tesla stock just over a year ago in his Robinhood account and it's now worth $60,000. In other words, he has a $50,000 long-term gain on his Tesla stock. He bought it for $10,000 just over a year ago and now it's worth $60,000. So he's sitting here with this $50,000 long-term capital gain. But here's the deal.

Tom doesn't think Tesla's gonna stop here Tesla Tom thinks that Tesla's gonna keep going up and up and up and he doesn't want to sell his stock and

However, if Tom is right and Tesla stock keeps going up, his tax liability, in other words, his gain on his investment is just going to get higher and higher and higher. Plus, when Social Security kicks in at age 70 and his required distributions begin at age 72, Tom and Linda are easily going to be in a higher tax bracket, which means he's likely going to be paying at least 15% capital gains on his Tesla stock when he finally sells.

To combat the issue of a higher future tax bill, Tom can take advantage of tax gain harvesting. He can simply sell all of his Tesla stock today, realize $50,000 of long-term capital gains at 0%, and immediately repurchase $60,000 of Tesla stock.

So by doing this, he'll still get to continue holding his precious Tesla stock for the long term, but he just reset his cost basis to $60,000. In other words, he'll only pay capital gains tax on gains above $60,000 going forward instead of his original purchase of $10,000. So needless to say, Tom is pretty excited about this, especially since he knows that his taxes are going to be a big hurdle for him at age 72 when all this other income kicks in.

If you're paying close attention there, I know it was a lot, but if you're paying close attention, you notice that I said Tom could immediately repurchase his Tesla stock.

Now, this is one of the great advantages of tax gain harvesting when compared to tax loss harvesting. With tax loss harvesting, as you might know, you have to navigate around what's called the wash sale rule. And just in short, you can Google it on your own, but in short, the wash sale rule says that if you sell an investment at a loss, you have to wait 30 days to buy it back. But thankfully, that doesn't apply to tax gain harvesting. Tom can sell his stock,

harvest the gain, and then immediately buy it back. There's no wash sale rule. Now, last week we talked about Roth conversions as a way to lower your tax bill. And you might wonder why Tom and Linda would be filling up his existing tax bracket by realizing capital gains instead of processing a Roth conversion and getting money out of his retirement accounts.

Now, there's a lot of factors at play here, but Tom worked with his financial advisor to determine his lifetime tax bill. And through that process, he learned that at the very least, he's going to be in the 22% tax bracket at age 72 when his RMDs kick in on top of Social Security.

So again, as a reminder, Tom right now is in the 12% tax bracket for ordinary income. He's projected to be in at least the 22% tax bracket at age 72. So if he did a Roth conversion, he would really only be realizing a 10% benefit. That's the 22% minus the 12% where he's at today. There's about a 10% benefit there for him to do a Roth conversion today, which is not bad.

But by harvesting capital gains at 0%, he's essentially realizing a 15% benefit instead of a 10% benefit because 15% is the next highest capital gains tax bracket, which he's going to end up in when his required minimum distributions kick in.

Plus, on top of that simple math, it's pretty hard to beat paying 0% on anything. So a lot of times people favor, if they're in this position, they favor realizing that 0% rate and harvesting those gains. So for Tom and his situation, harvesting those gains at 0% this year made more sense than a Roth conversion.

By the way, gains harvesting is not just for those that qualify for 0% long-term capital gains rates. There are plenty of scenarios where harvesting gains at 15% or even 18.8% can make more sense than getting stuck paying that same rate or more on a larger balance in the future. Remember, historically, the stock market ends the year in positive territory three out of every four years.

So the longer you wait to pay taxes on an investment, the better chances are you'll be paying taxes on a higher balance.

But I want to be sure to emphasize how important it is to take all the planning opportunities into consideration before pushing the button on gains harvesting, because one tax planning strategy can easily impact another. For example, if you have other income sources, or maybe you plan to do some partial Roth conversions, the amount of capital gains that you can harvest at 0% gets reduced.

Also, realizing additional income through Roth conversions or gains harvesting, as you might know, can cause Social Security to become taxed and your Medicare premiums to increase.

Also, more complex things can come into play like charitable giving plans, changes in state income taxation, and future tax rates of your retirement accounts that are going to be inherited by your heirs. So it's this balancing act between Roth conversions and gains harvesting and some of these other tax planning strategies that must be properly navigated each and every year to ensure that your unique financial goals are all met and all of the opportunities are maximized.

To try and help simplify some of your decision-making here, I want to leave you with three reasons why you might not want to harvest capital gains.

Number one is if you plan to hold securities until death. And in this case, if you plan to, if Tom plans to hold his Tesla stock until death, his heirs will receive what's called a step up in basis, which is likely going to be more impactful than harvesting his, his capital gains while he's still alive. So for example,

So Tom's Tesla stock, right? He bought for $10,000. Let's say that he intended to hold it till death. And when he died at age 100, it's now worth $500,000.

His child, he's got one child. His only child is going to inherit this $500,000 of Tesla stock. And the cost basis is going to immediately step up to that $500,000, meaning his son could sell all $500,000 worth of stock and not pay any taxes on it. That's that step up in basis. So if you plan to hold securities until death, have a long-term capital gains, then, you know, harvesting gains now while you're alive may not make sense.

The second reason is if you're at the upper end of the 35% tax bracket and you're already paying the maximum of 23.8% on long-term capital gains.

It depends on what your future tax bill might look like, but if you do anything at all in the tax funding department, it likely makes more sense to fill up your 35% ordinary income tax bracket, which would save you two percentage points before reaching that next bracket of 37%. So if you do anything at all, and again, it depends on a multitude of factors, but it probably makes more sense to fill up that 35% tax bracket rather than paying the maximum amount on long-term capital gains.

As mentioned earlier in the show, gains harvesting really does benefit the middle class and the mass affluent, the ultra rich who are already in the higher two tax brackets, not so much. Number three, the third reason why you might not want to harvest capital gains is if you have a lot of carry forward losses. In other words, if you have losses from previously sold securities that can be applied to future gains.

In this situation, it likely makes more sense to apply these losses against higher future tax rates than to absorb them now while you're in a low tax bracket. If you're not sure if you have carry forward losses or not, your financial advisor or tax professional should be tracking this and should be able to tell you if you have them. If you have a lot of carry forward losses, again, that's a third reason why you might not want to go forward with tax gain harvesting.

So as you can tell, as I've already mentioned, there are a lot of moving parts at play here and pulling one lever can impact another. The big idea that I wanted to bring to the surface is that the one takeaway for you is this idea of harvesting gains versus losses, especially if you're in your gap years and you can take advantage of your low tax bracket.

For the links and resources mentioned today, head over to youstaywealthy.com forward slash 90. Thank you as always for listening. And I'll see you back here in two weeks for more year end tax planning strategies. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial or other professional services.