Low Tax Bracket? Consider Harvesting Gains

Note: This article is part of Morningstar's November 2016 Year-End Tax-Planning Guide special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors might be familiar with tax-loss selling, but tax-gain harvesting is a little bit less familiar. I'm here with Christine Benz, she is our director of personal finance, to look who the strategy is appropriate for.

Christine, thanks for joining me.

Christine Benz: Jeremy, great to be here.

Glaser: So, let's start with what tax-gain harvesting is. What exactly is happening here, and who can actually use this strategy?

Benz: The basic idea is that if you have appreciated positions, the name of the game is that you go ahead and pre-emptively sell them. And the reason that you might consider it is if you are an investor who is in either the 10% or 15% income-tax bracket, there is a 0% long-term capital gains rate that applies to you. So, the idea is that you go ahead and you realize the gain. You don't pay any taxes because you're in those lower tax brackets, and then you can repurchase that same security. And the value of doing that is that you are stepping up your cost basis. You are increasing your cost basis. And the reason why you would want to consider that is that if you are in a higher bracket for long-term capital gains in the future, that you could go ahead and sell that position, and the taxes you would owe would be on the difference between its current purchase price and your new higher purchase price. So, that would mean a lower tax bill if and when you eventually sell that position.

It's also worth thinking about if you think taxes at a secular level will go up. So, not just your own tax rate but taxes as they apply to everyone. If you think that that long-term capital gains rate will eventually go up across the board that you might think about pre-emptively realizing a gain and getting yourself into a higher cost basis.

Glaser: So, is there an equivalent of wash-sale rule here? Can you purchase that security again immediately?

Benz: You can, and that's the neat thing about this strategy--that even if you want to hang on to the very same position, you can go ahead and rebuy it right away, whereas if you're engaging in tax-loss selling and you want that tax loss to count, you have to wait at least 30 days to rebuy the same position. So, it's a neat strategy in that it allows you to maintain identical equity exposure or identical market exposure.

Glaser: So, if you are looking to execute this, I know a lot of things have been up, but where do you think would be some places to look for potential gains?

Benz: Well, the good news is, as you alluded to, Jeremy, we've had this broad-based rally, especially in U.S. equities where returns have been particularly strong. To the extent that investors have equity positions and they have held them for any period of time at all, it's a good bet that they have appreciated positions among their holdings. So, you don't have to look too deeply into a portfolio. If you are in the 10% or 15% income-tax brackets to identify some of these tax-gain harvest candidates.

Glaser: And if we were to see markets pull back some, would you then be able to use these positions for tax-loss sale, there would be no restrictions there?

Benz: That's the neat thing about this strategy, and I think arguably that's a reasonable expectation at this point in time that we will see some pullback in the equity market. 2016 has been a pretty strong market for stocks. So, the nice thing about having pre-emptively harvested some of the gains and stepped up your cost basis is that if equities decline, you will be more likely to find candidates for tax-loss sales in the future. So, it can be a neat strategy regardless of what happens to the market.

Glaser: Now you can repurchase that same security right away. But there also could be an opportunity to upgrade your portfolio.

Benz: That's right. Any time we talk about these tax strategies, I love when you can find a way to make them line up from an investment standpoint, too. So, if you are thinking about undertaking such a strategy, maybe you are a person who is in that 0% long-term capital gains rate right now, you can go ahead and realize your gain in the position but potentially get into something you like better. So, a great example is for the person who has maybe a heavily concentrated position in an individual stock or handful individual stocks, or maybe some sector-specific fund or ETF, it's a way to shake loose some of the profits that you've made and then deploy those assets into a position that gives you a little better diversification, maybe sets your portfolio up with a better risk-return profile going forward.

Glaser: And even if you are not paying capital gains tax, there still could be some transaction costs involved with this maneuver.

Benz: That's such an important point. The good news is that fewer and fewer investors are paying big commissions or even big fund loads, but definitely take your transaction costs into account. They could erode the benefits of engaging in the strategy.

Glaser: And finally, you think this is the maneuver you really should do with the tax advisor given that it could shift things around in unexpected ways.

Benz: That's right. So, it's important to remember that these gains that you are going to be realizing do have an effect on your income-tax bracket. So, keep that in mind. Definitely, proceed with the assistance of either a tax-savvy financial advisor or a tax advisor before you pull the trigger on realizing some of these gains. One thing you might keep in mind is that this may be a multiyear strategy for you, that maybe you can undertake this over a period of years as long as you are in that--as long as that 0% long-term capital gains rate applies to you, maybe you can do these tax-gain harvests over a period of a few years.

Glaser: Christine, thanks for sharing your thoughts on this today.

Benz: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.