Tax-Gain Harvesting Can Be a Valuable Strategy for New Retirees

Tax-loss selling is often touted as a worthwhile year-end tax planning strategy. But as 2017 winds down, most investors who go out looking for meaningful losing positions in their taxable portfolios will come up empty-handed.

Through early December, all but three mutual fund categories are in the black thus far this year. (If you're curious, the losers are bear market, equity energy, and equity limited partnership funds.) Individual stock investors might more readily be able to pick off losing positions to generate a tax loss, but even they might struggle to find critical mass: Just 71 of more than 1,500 large-cap companies in Morningstar's database have lost more than 10% of their value so far this year. Even though strong appreciation in the equity market, combined with another tough season for mutual fund capital gain distributions, means that investors could really benefit from tax losses in their portfolios, losers are hard to find.

Yet even as candidates for tax-loss selling may be few and far between this year, another tax-harvesting strategy looks to be better suited to this year's buoyant market conditions: tax-gain harvesting. The strategy will only benefit a fairly small subset of the investing public--investors who have substantial assets in their taxable accounts and are in the 15% tax bracket or below. (For 2017, single filers with less than $37,950 in taxable income and married couples filing jointly with less than $75,900 in taxable income pay a 0% rate on long-term capital gains.) The fact that such investors currently pay a 0% rate on long-term capital gains gives such individuals the opportunity to adjust their portfolios without any tax cost, and potentially improve their tax situations down the line.

New retirees who are able to keep their incomes down because they're not working and not yet subject to RMDs are prime candidates for this type of tax-gain harvesting. Vanguard retirement guru Maria Bruno has called this life stage the "sweet spot" for maneuvers to lower future tax bills, such as converting traditional IRA assets to Roth.

Capital Gain Harvesting Unpacked For investors inculcated in the all-purpose tax-management philosophy of "accelerate deductions, delay gains," tax-gain harvesting seems highly counterintuitive. Why on earth would you want to pre-emptively realize a gain?

The key reason to do so is if you won't owe taxes on those gains, as is the case with investors who are in the 10% and 15% income tax brackets currently. Such investors pay no federal taxes on long-term capital gains. That gives them the opportunity to sell their appreciated winners without tax consequences.

Such a strategy can come in handy in a few separate instances. One is to maintain basic portfolio hygiene. Investors who are in the 25% tax bracket and above will pay capital gains tax if they need to reposition their taxable portfolios; that's the key reason it usually makes sense for such investors to concentrate any rebalancing activity within their tax-sheltered accounts. But investors who are in the 10% or 15% income tax brackets won't face federal tax consequences when scaling back their equity holdings from their taxable accounts, provided they don't realize such high gains that they push themselves out of the 15% income-tax bracket. They can steer the proceeds from the equity sales into their cash buckets if they're retired, or into bonds. (Assuming they're reinvesting the equity-sale proceeds in a taxable account, municipal bonds might make sense.) In a related vein, investors in the 10% and 15% income tax brackets can also sell problematic positions from their taxable accounts without triggering capital gains taxes, provided their sales don't inadvertently push themselves into a higher income tax bracket.

And even if investors wish to maintain their portfolios as they are currently, tax-gain harvesting allows them to reset their cost basis, thereby reducing the taxes that they'll owe when they eventually do sell. If they know they'll remain in the 15% income tax bracket or below even factoring in the sale, investors can sell appreciated securities and re-buy them immediately thereafter at today's lofty prices. If the securities appreciate after the investor re-buys them, the difference between the higher cost basis and the sale price would be lower than if they stood pat with their old, lower-cost-basis shares. And if the securities decline after resetting the cost basis, the investor may be able to book a tax loss. This strategy can be especially beneficial if the investor is only temporarily parking in the 0% capital gains lane and expects his or her capital gains rate will eventually go up.

To use a simple example, let's say Jack made a $10,000 investment in

Now let's assume that Jack is in a higher income-tax bracket five years in the future, and he now owes capital gains taxes at a 15% rate. If he needs to sell his Vanguard Total Stock Market Index position, the fact that he stepped up his cost basis in 2017 would reduce the taxes due at the time of sale. If his position had increased to $36,000, he'd owe capital gains on that $8,000 in new appreciation, or $1,200 in taxes, assuming he sold all of his shares. Had he not stepped up his basis in 2017, the tax hit would be calculated the spread between his initial cost basis ($10,000) and the price of his stake at time of sale ($36,000). His total tax tab would be $3,900--based on his 15% long-term capital gains rate and the $26,000 in appreciation over his holding period.

Retirement "Sweet Spot" As noted, it's not too common for investors to amass substantial taxable assets while having income that's modest enough to qualify for the 10% or 15% income tax brackets/0% long-term capital gains rate. However, some early retirees fit the bill, especially if they're no longer earning paychecks and RMDs haven't yet commenced; in those years, they have an unusual amount of control over their taxable income.

Tax-gain harvesting can make sense for this cohort on a couple of levels. First, many such investors have higher equity holdings than is ideal; they can reposition their portfolios without tax costs. Moreover, by washing taxable capital gains out of their portfolios, tax-gain harvesting gives them the opportunity to lessen the amount of taxes due when they eventually do sell those positions. When RMDs commence, for example, they may no longer be eligible for the 0% long-term capital gains rate.

The tricky part of making sure that tax-gain harvesting is a viable strategy is to ensure that in fact your taxable income--including the capital gain--comes in below the 15% threshold. Additionally, realizing capital gains has the potential to increase a taxpayer's adjusted gross income, which can affect allowable deductions. It's also worth noting that many states tax capital gains. All of these considerations make it crucial to check in with a tax advisor--or run your numbers using tax-preparation software--before pre-emptively realizing capital gains.

Moreover, uncertainty about tax rates beyond 2017--especially potential changes in tax brackets--means that investors who aren't eligible for 0% long-term capital gains rates should think twice before pre-emptively realizing gains that they'll in turn owe taxes on. For them, the evergreen admonishment to "defer gains" makes sense.