The stock market has been on a tear lately. And by lately I mean the last 9 years. If you have ridden these gains for any amount of time during this bull market, it is time to consider locking in them through a strategy called Tax-Gain Harvesting.
Tax-gain harvesting is the opposite of the popular Tax-Loss Harvesting strategy that many investors are familiar with. (If you are not sure what tax-loss harvesting is, check out this great article by the Mad Fientest. It is worth the read and will help you understand this article.)
I used tax-gain harvesting at the end of 2017 to lock in $2,485 of investment gains in my taxable account. I was able to do this while paying 0% tax on those gains. I’ll explain the details soon, but first let’s take a look at what tax-gain harvesting is.
If you recall, tax-loss harvesting is when you sell investments at a loss to lower your tax bill by using those losses to offset ordinary income or capital gains.
Tax-gain harvesting is the opposite: you sell investments after they have appreciated to lock in their value and adjust their cost basis.
By selling appreciated investments and immediately repurchasing them, you have secured the gains from the price appreciation. Also, since the shares were sold at a gain, the wash sale rule does not come into effect.
Tax-savvy investors will immediately recognize that selling an investment that has appreciated in value creates a taxable event. Typically, I would suggest avoiding actions that incur extra taxes. However, there are certain scenarios where it can be an effective strategy.
Let me explain.
Understanding Your Investment Gains
Tax-gain harvesting only works when you are selling Long-Term Capital Gains. These are considered gains on investments that have been held for longer than one year.
Any appreciation of investments held less than one year are considered Short-Term Capital Gains and are taxed at your ordinary income tax rate.
Long-term capital gains rates are different. In 2017, the long-term capital gains tax rates are based on your federal income tax bracket:
As you can see, most people will wind up paying either 0% or 15% for their long-term capital gains, with only the highest earners paying more than that.
Since this post is coming out in January 2018 and the US Congress passed the tax reform bill (known as the Tax Cuts and Jobs Act), the above table does not accurately represent the long-term capital gains tax rates that will be in effect this year and beyond. Please do not use the above table to make tax-gain harvesting decisions in 2018 or beyond.
Two Reasons to Tax-Gain Harvest
Reason #1: If you fall into the 10% or 15% tax brackets, your long term-capital gains tax is 0%. If this is you, tax-gain harvesting is a no-brainer. Just be careful that the amount of gains you sell does not push you from the 15% tax bracket to the 25% bracket.
Reason #2: Adjusting the cost basis of your investment to take advantage of tax-loss harvesting at a future date.
For example, if you had bought $10,000 of VTI (Vanguard Total Stock Market ETF) at $100 a share three years ago and the price of those shares are now $140, you have an investment gain of $4,000. By selling those shares at $140 a share and then immediately repurchasing, you have adjusted your cost basis to $140 per share versus your original cost basis of $100 per share.
By adjusting your cost basis higher, you are likely able to take advantage of tax-loss harvesting sooner than you would have at a $100 per share cost basis.
Investment losses can offset up to $3,000 a year in ordinary income or long-term capital gains. When the cost basis is adjusted up, the chance to harvest investment losses increases.
Please note: tax-gain harvesting is an advanced investment strategy and shouldn’t be done without thorough research of the tax implications. If you will owe tax on your long-term gains, it may be worth your while to speak to a professional to fully understand your tax situation.
How I Earned $2,485 of Tax-Free Gains
My wife and I will be in the 15% income tax bracket when we file our 2017 taxes. Recall from above, being in the 15% tax bracket means that I will owe zero taxes on any long-term capital gains.
Near the end of 2017, I started looking for ways to take advantage of this opportunity.
I found the perfect fit in my taxable (aka “Build Wealth”) account with Betterment. My portfolio had seen major growth over the past two years and was primed for this opportunity.
Over this time, I had invested $8,160 and earned $2,642, bringing my portfolio to ~$10,800.
Knowing that the majority of this money had been invested over a year ago, I selected the “sell” option in my account to see what the estimated tax impact of selling everything in here would be.
Before finishing the sale, Betterment includes and estimated tax impact to review:
While Betterment estimated I could owe upwards of $859 in taxes, their algorithms didn’t recognize that my federal income rate will be 15% and that I live in a state with no income tax.
This means I will pay 0% on any long-term capital gains and only 15% income tax on any short-term capital gains.
The two green numbers below this estimated tax impact are what really matter: $2,485 in net long-term gains and only $30 in net-short term gains.
I had found the perfect tax-gain harvesting opportunity.
By selling all the shares I owned with Betterment, I was able to lock in $2,485 of long-term capital gains and pay no tax on them. I will owe $4.50 on my short-term gains, but that’s well worth it in this situation.
Locking in the Gains
As I have said above, the purpose of tax-gain harvesting is to adjust your cost basis. The only way to adjust it is to immediately repurchase those investments.
However, part of the reason I chose to sell my Betterment investments was to gain more control over my portfolio and stop paying their management fee of 0.25%. Don’t get me wrong – I think Betterment, and robo-advisers in general, can be great investment options for many people, but I wanted to change things up.
I have had two 401(k) accounts with Fidelity and have always been pleased with their customer service and investment options.
So when I decided to sell my Betterment investments and lock in my capital gains, I decided I would move that money to an individual brokerage account at Fidelity.
I followed a used a similar index-fund approach and purchased shares of ITOT (iShares Total US Stock Market ETF), IXUS (iShares MSCI Total International Stocks ETF) and AGG (iShares Barclay Aggregate Bond Fund).
This isn’t the exact makeup that I had at Betterment, but it’s more aligned with what I want in my portfolio and the total value of the portfolio did not change. In effect, I used this tax-gain harvesting activity to re-balance my portfolio to better align with my goals.
By executing a successful tax-gain harvesting strategy at the end of 2017 I was able to:
- lock in long-term capital gains without paying any tax;
- transfer my taxable account from Betterment to Fidelity, giving me greater control of my investments and avoiding a 0.25% management fee;
- explain tax-gain harvesting and share a real life example with you, the readers!
Have you ever executed a tax-gain harvesting strategy or considered it?
Especially share if you have done so knowing you would pay at 15% or more tax on the long-term gains! It would be great to hear about a story like that.