Tax-Gain Harvesting Can Be a Profitable Strategy
'Stepping up' cost basis can reduce tax bills for lower-income investors.
Personal finance experts often suggest that you put tax-loss selling on your year-end financial-planning to-do list. By selling positions that are trading below your purchase price, you can then use those losses to offset any capital gains that you've realized in your taxable portfolio and, if your losses exceed your gains, up to $3,000 in ordinary income.
That sounds good, but as 2016 winds down, most investors would be hard-pressed to identify many losing positions in their portfolios. Stocks have enjoyed a tremendous bull run going back to 2009; as of this writing, all but a handful of mutual fund categories are in the black over the past three and five years. Individual-stock investors may have an easier time unearthing positions that are trading below their purchase prices; company-specific events can derail individual-equity prices even as the broad market is moving up. Unless you're a very high net-worth investor or have had very bad luck picking individual stocks, however, losses on one or a handful of individual positions may not result in a big tax break.
The strategy of tax-gain harvesting, by contrast, is perfect for bull markets, when many investors are sitting on substantial embedded capital gains. True, capital-gains harvesting is only a worthwhile strategy for a small subset of the investing public: investors who are currently in the 10% or 15% income-tax brackets who are holding taxable (i.e., nonretirement account) assets. But for such investors, tax-gain harvesting can be a winning strategy.
The Why and How of Tax-Gain Harvesting
The current zero capital gains rate for lower-income investors, ushered in at the beginning of 2008, made tax-gain harvesting a viable strategy. The basic idea is that investors who land in the 15% tax bracket or below--in 2016, that's single filers with taxable incomes of $37,650 and married couples filing jointly with taxable incomes of less than $75,300--can sell appreciated winners. Because they pay no federal taxes on long-term capital gains, they won't owe any taxes on the appreciation. They can then re-buy the same securities straightaway, thereby resetting their cost basis in the security to its new, higher level, based on today's prices. If tax rates go up in the future--either the investor's own tax rate or tax rates at the secular level--the investor will pay capital gains tax on the spread between the cost basis on the most recent purchase and the selling price.
To use a simple example, let's say Jack made a $50,000 investment in Vanguard Total Stock Market Index (VTSMX) in 2005, when the fund's net asset value was just about $28. Today, his position is now worth $115,000, and the fund's NAV sits at $53. Assuming he's in the 10% or 15% income tax bracket, he could sell the position to essentially wash out his $65,000 profit, with no federal tax cost to him. He could then re-buy the same fund at today's current, higher NAV. (In contrast with tax-loss selling, no wash-sale rules govern tax-gain harvesting; you don't have to wait 30 days to re-buy the same security.)
Tax-gain harvesting is free from federal tax for those in the 15% tax bracket or below, but what's the upside? The key benefit is that resetting the cost basis to its new higher level reduces the taxes that will be due if an investor is eventually in a higher tax bracket, either due to changes in his or her income situation or long-term capital gains rates at large. (Before 2008, investors in the lowest tax brackets paid a 5% long-term capital gains rate, and before that, investors in the 10% and 15% tax brackets paid an 8%-10% capital gains rate.)
Going back to the earlier example, if Jack's in the 25% tax bracket five years from now and he needs to sell his Vanguard Total Stock Market Index position, the fact that he stepped up his cost basis in 2016 would reduce the taxes due at the time of sale. If his position had increased from $115,000 to $150,000, he'd owe a 15% capital gains rate (assuming tax rates hold steady between then and now) on his $35,000 in new appreciation, or $5,250, assuming he sold all of his shares. Had he not stepped up his basis in 2016, the tax hit would be calculated on the whole $100,000 in appreciation--the spread between his initial cost basis ($50,000) and the price of his stake at time of sale ($150,000). His total tax tab would be $15,000--based on his 15% long-term capital gains rate and the $100,000 in appreciation over his holding period.
Not Only Beneficial If Stocks Go Up
Pre-emptively realizing capital gains by selling and re-buying the shares doesn't just carry a benefit in rising markets; it can also be helpful in losing ones, as a higher cost basis makes it easier to find candidates for tax-loss sales. Going back to our example, say U.S. stocks, and in turn Vanguard Total Stock Market Index, drops 20% after Jack harvests his gains and repurchases his shares. He could sell his position and take a $25,000 tax loss, on the difference between his cost basis of $115,000 and his account's current value of $90,000. (The wash sale doesn’t apply to tax-gain harvesting, but it would apply to the tax-loss selling detailed here; Jack couldn't re-buy a total stock market index fund without triggering the wash sale and effectively undoing his tax-loss.) He wouldn't have had that opportunity had he not engaged in tax-gain harvesting, as his initial cost basis of $50,000 would be well below the account's current value of $90,000.
Tax-gain harvesting can have a salutary portfolio benefit: While the previous examples have all focused on re-buying the same security following tax-gain harvesting, investors in the 10% and 15% income tax brackets can also take advantage of their zero long-term capital gains rate to improve their portfolios. Say, for example, Jack was holding a highly concentrated position in an individual name or sector; while performance may have been strong, the risk of that hefty position has grown, too. Tax-gain harvesting enables him to reduce the risk of that position at no federal tax cost, while also stepping into a higher-basis portfolio mix.
The crucial aspect to making tax-gain harvesting effective, of course, is that the investors is in the 15% income tax bracket or below, factoring in the amount of the capital gain. (Michael Kitces does a deeper dive into the tax complexities in this post on his Nerd's Eye View blog.) Additionally, realizing capital gains has the potential to push up a taxpayer's adjusted gross income, which can affect allowable deductions. Moreover, while a 0% federal capital gains rate is currently in place for investors in the lowest tax brackets, many states tax capital gains; state capital gains taxes could cut into the benefits of the strategy. For all of these reasons, it pays to consult a tax advisor before embarking on a strategy of capital gains harvesting.
Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.