Taxes are a significant expense for most Americans. As such, savvy investors have come to appreciate the dramatic impact careful management of taxes can have on overall investment returns.
For instance, when markets have a rough year and portfolios are down, many investors take advantage of tax loss harvesting by selling assets that have depreciated in value for potential future tax benefits.
But not every investor is aware that you can also harvest gains. When executed strategically, tax gain harvesting may help save you money, decrease taxes, and manage risk in your portfolio.
What Is Tax Gain Harvesting?
Tax gain harvesting is a strategy that involves selling investments that have appreciated in value to realize a gain and then reinvesting the proceeds. This strategy aims to reduce the tax burden on future investment returns.
In many ways, the approach is similar to tax loss harvesting, with a few key distinctions.
Both tax gain and tax loss harvesting involve identifying suitable investments, selling those investments, potentially reaping the tax benefits, and potentially repurchasing the shares. However, they have some key differences.
With tax loss harvesting, investors sell an investment that has dropped in value from the initial purchase, reducing the cost basis. They then use this realized loss to offset any taxable income or capital gains from other parts of the portfolio to minimize taxes in the current tax year. However, this strategy can lead to potential disruption in the current asset allocation and a larger capital gains tax bill in the future.
On the other hand, tax gain harvesting focuses on selling investments that have risen in value to incur the taxable consequences now, repurchasing the investment, and minimizing capital gains taxes in the future.
When To Consider Tax Gain Harvesting
Tax gain harvesting may be suitable in specific scenarios, such as when an investor in the 0% long-term capital gains tax bracket anticipates being in a higher tax bracket in the future, has had significant growth in an investment, or wants to rebalance a portfolio.
For 2023, investors may qualify for the 0% long-term capital gains rate with taxable income of $44,625 or less for single filers and $89,250 or less for married couples filing jointly.1
The rates use “taxable income,” calculated by subtracting the greater of the standard or itemized deductions from your adjusted gross income. Your income is also “lowered” by any retirement plan and medical plan contributions you make (within 2023 limits).
For example, a married couple making $115,000 in 2023, after subtracting the $27,700 married standard deduction, would have a taxable income below $89,250 and pay 0% in long-term capital gains.
When To Consider Tax Gain Harvesting
Tax gain harvesting is the process of turning unrealized gains into realized gains by selling an investment that has increased in value.
The process of tax gain harvesting involves several steps.
- Identify the investments in the portfolio that have appreciated
- Select specific assets to sell and “realize” the capital gains
- Reinvest the proceeds into the same or similar assets
- Pay taxes (if any are due)
The most effective approach to tax gain harvesting involves tracking the cost basis for specific shares instead of using average cost basis or first-in-first-out (FIFO) to identify and understand the tax implications of particular shares and make informed decisions about which to sell.
When identifying investments with gains to harvest, it’s important to understand the difference between short- and long-term capital gains.
- Short-term capital gains are profits from selling an asset held for a year or less. These gains are added to income and taxed at the regular income tax rate.
- Long-term capital gains are profits from selling an asset owned for over a year. Based on taxable income, the long-term capital gains tax rate is 0%, 15%, or 20%. Usually, long-term capital gains tax rates are lower than short-term rates.
Tax gain harvesting converts potentially significant long-term tax gains into smaller and nearer-term tax liabilities.
Hypothetical Example:
An investor has a stock that has appreciated significantly, which they would still like to hold to and own. After review, they have determined that they will fall into the 0% capital gains tax bracket this year but expect to be in a higher bracket (15%) in the future.
Note: Investors may be familiar with the importance of the wash sale rule for tax loss harvesting. A wash sale occurs when an investor sells a security and then repurchases it (or another security that is “substantially identical”) within 30 days. In this case, the tax loss can no longer be claimed for tax purposes.
However, the wash sale rule does not apply to tax gain harvesting. An investor can immediately purchase the same investment (or a similar investment) after harvesting gains. This allows investors to stay fully invested and not risk time out of the market while maintaining their asset allocation.
Potential Benefits and Risks of Tax Gain Harvesting
Tax gain harvesting has several potential benefits. Realizing gains in a low tax bracket can potentially increase overall investment returns. This strategy also helps reduce taxes on future investment returns by resetting the cost basis of investments. Furthermore, it minimizes the tax impact on future sales, giving investors more flexibility to manage their portfolios without worrying about a significant tax hit.
Tax gain harvesting can help investors reduce future taxes and boost their overall investment returns. However, like any financial strategy, it isn’t without risks. Market volatility, future changes in tax laws, or a shift into a higher tax bracket could make tax gain harvesting less beneficial.
However, while this strategy can potentially minimize capital gains taxes at the federal level, investors may still be subject to taxes at the state level. Harvesting gains may even trigger an alternative minimum tax (AMT) or the net investment income tax (NIIT).
Before taking any action, consult with your financial advisor and your tax professional to ensure you don’t end up with any unexpected tax consequences.
To Sum Up
Tax gain harvesting is a potent strategy that can help savvy investors maximize their returns and minimize their tax liabilities. While it requires careful planning and consideration of potential risks and benefits, engaging in this process can help investors keep more of what they earn over time and ensure their investments continue to thrive.
1. Jackson, A., “What Are Capital Gains Taxes?” Wall Street Journal, September 30, 2023. https://www.wsj.com/buyside/personal-finance/capital-gains-tax-523f6394
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