Tax gain harvesting is an interesting technique which I only recently learned about. It takes advantage of the 0% federal tax rate on long-term capital gains if your income is below $40,000 (individual) or $80,000 (married). Higher income earners typically pay 15%, but if your 2020 income was impacted by the pandemic you may have an opportunity to lock in some investment gains tax free. This can also be a useful tool for young people, early retirees, or anyone with a temporary drop in income.

The rules:

• Long term capital gains taxes are applied to assets held for greater than one year.
  • The gain is the difference between the sale price and the basis (typically the purchase price).
• For 2020, the federal tax rate for long term capital gains is 0% if income is less than:
  • $40,000 for single filers
  • $80,000 for married couples
• For 2020, the standard deduction is:
  • $12,400 for single filers
  • $24,800 for married couples
• After selling an asset for a gain, there are no restrictions or tax implications if you reinvest in the same asset.
• The rules vary from state to state, so you may incur some state tax liability.

You may be able to implement this strategy if:

• You have reduced income in 2020 and have significant unrealized capital gains in a taxable account.
• You anticipate a future year with reduced income due to job transition, leave of absence, or early retirement.
• You expect to have a few years of lower income in retirement before required distributions from retirement accounts kick in.
• You have children.

The Strategy for 2020: Your income, including capital gains, minus the standard deduction must be less than the top of the 0% capital gains tax bracket. You need to have assets in a taxable account which have increased in value and have been held for greater than one year. Prior to selling, ensure the gains will not push you over the top of the capital gains tax bracket. Sell the assets and then immediately repurchase (if desired). Make sure you have considered all sources of income to include dividends, capital gains, second jobs, etc. when doing your calculations.

The Strategy for the Future: If you anticipate you, or someone in your family, will have low income in future years you can set yourself up to use this strategy. In this scenario, you would invest in assets you expect to appreciate over time in a taxable account. For example, you could invest in an S&P 500 index fund at E-Trade (see my Referrals Page). When you reach your target low income year, you can sell the assets with no tax liability. You can either use the money or reinvest with a higher cost basis which will result in a lower tax bill when you ultimately sell the asset.

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Example 1: Let’s say you are a married couple with combined income of $120,000. Due to the pandemic, one of you had to leave your job to care for children when schools closed. As a result your 2020 income will be $70,000. Over the years you’ve invested in a taxable brokerage account (i.e. outside of a retirement account). Your current balance is $100,000 of which $30,000 is capital gains. If you were to sell all of this, you would normally be taxed at 15% resulting in a $4,500 tax bill. And if you wait to sell in a future year with typical income you will be stuck with this tax bill. But if you sell before the end of 2020, your tax rate will be 0%. Your total income of $100,000 falls below the $80,000 threshold when you subtract the standard deduction of $24,800. And assuming you are happy with your current investments, you can immediately reinvest in them.

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Example 2: You have a 10 year old son. Each year he invests $2,000 in an S&P 500 index fund through his 21st birthday. This could be money he earned or received as gifts. He ends up with contributions totaling $24,000 (the basis) and it would not be unreasonable to expect $10,000 to $15,000 of growth. Depending on how much he works during high school and college, he could increase the contributions resulting in $20,000 or more of capital gains. He could now sell these assets in his final low-income year and owe $0 in federal tax. He could reinvest in the same assets or use the money to get started with life after college. By tax gain harvesting prior to his first high-income year, he could save $3,000 dollars or more in federal taxes.

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***The Content in this blog is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.***