Gain harvesting is where investors can sell taxable investments with long-term capital gains and not owe capital gains taxes. For 2018, you must have taxable income below $38,600 if single, $77,200 if married filing jointly and $51,700 if head of household to not owe taxes on long-term capital gains and qualified dividends. Any long-term capital gains above this taxable income threshold will be subject to the regular 15% tax on long-term capital gains, while the gains below the threshold are tax-free. Income is often much lower in retirement, especially before taking the required minimum distributions from retirement accounts at age 70.5, so many retirees have room to realize gains without tax consequences.
So what’s included in taxable income?
Taxable income is the total of your sources of income, which includes earned income, investment income, retirement distributions, the portion of social security that is taxed and pension income. Once these sources of income are added up, you can then subtract the higher of your standard deduction or itemized deductions to arrive at taxable income. In 2018, the standard deduction is $12,000 for single and $24,000 for couples filing married filing jointly (extra $1,300 per person if above age 65 and/or blind).
If you’re receiving Social Security benefits and filing jointly with a combined income between $32,000 and $44,000, then 50% of your Social Security benefits is taxable. If your combined income is above $44,000, then 85% of your benefits is taxable. Combined income is your adjusted gross income, plus nontaxable interest (municipal bond interest), plus half of your Social Security benefit. If this amount is above $44,000, then 85% of your Social Security benefit is included in calculating your taxable income. If 85% of your Social Security benefits is not already included in your taxable income, be aware that realizing capital gains may increase the taxability of your Social Security benefits, effectively pushing you into the 22% marginal tax bracket. To remain in the 12% tax bracket, you may need to reduce the amount of capital gains realized.
Why sell something that has increased in value?
At times it can appear counterintuitive to sell investments that have significantly increased in value to buy investments that have fallen in value. However, more often than not, those investments have grown to be a significant part of one’s portfolio, thereby reducing overall diversification and increasing portfolio risk. In other words, gain harvesting provides a tax-efficient way to rebalance your portfolio to long-term targets. It also allows you to free up cash to cover expenses or gifts without incurring any capital gains taxes.
As an example, consider a retired couple, both age 66, living off of Social Security benefits, retirement account distributions, and dividends and capital gains from their taxable investment account. This couple has a $1 million taxable investment account with $400,000 in long-term capital gains. As you can imagine, their portfolio has probably drifted out of balance due to the significant capital gains. To move their portfolio back to its long-term targets for their risk tolerance, they want to sell enough stocks to rebalance their portfolio with minimal tax consequences, if any.
The following scenarios illustrate the tax implications of this couple selling investments in their taxable investment account for a gain with varying levels of taxable income.
The couple has taxable income of $40,000. They can realize $35,000 in long-term capital gains without owing any capital gains taxes.
The couple has taxable income of $70,000. They can realize $7,000 in long-term capital gains without owing any capital gains taxes. Any gains realized above this amount are subject to the 15% long-term capital gains tax.
The couple has taxable income of $100,000. Their taxable income is already above $77,200, so they are not able to realize any capital gains without owing capital gains taxes. Long-term capital gains realized above this point will owe 15% capital gains taxes.
Since taxes can eat away a significant part of the value and return of your portfolio over time, taking advantage of benefits in the tax code in years where your income may be lower, whether in between jobs or in retirement, is a prudent move. This is especially important when your portfolio has drifted away from long-term targets.
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Geoff has always enjoyed talking with people about finance, learning about their investments, financial strategy, and business sense. His interest only deepened with time, and what began as a hobby has now become a life-long passion, with an unparalleled passion for continuing education that makes him an expert in many subjects from traditional taxes and investments to business succession planning and executive compensation negotiations.
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