If done appropriately, tax gain and loss harvesting in your non-retirement accounts can help you reduce or defer taxes, thereby keeping more money in your pocket!
More specifically, I discuss:
- Tax loss harvesting with examples
- Tax GAIN harvesting with examples
- How capital gains and losses are taxed
- When it’s a good idea to implement this tool
- Common pitfalls to avoid when tax harvesting is implemented
- What is a capital loss carry-forward and how to use it
Resources From This Episode:
How to Harvest Taxable Gains and Losses
Welcome to Retired-ish. The podcast produced for those exploring retirement and those currently in retirement. I'm your host, Cameron Valadez, and today I'm talking about a strategy, or what I would actually call a tool in the toolbox, for retirees called tax loss harvesting, or more specifically, tax gain and loss harvesting.
Now tax harvesting is something investors, and retirees alike can use on an ongoing basis to help manage the annual tax bill in their non-retirement accounts and investments. So think trust accounts, transfer on death accounts, and regular brokerage accounts, which are essentially those accounts that you fund with money that was already sitting around in your bank account that you then at some point put into an investment account to go to work for you.
You can even use this tool to help offset potential capital gains or losses from real estate activity as well, and vice versa. Tax gain and loss harvesting is not a tool that you would use in a retirement account, however, since all of the money in those accounts is either fully subject to income taxes when you pull it out or, in the case of a Roth account is tax-free when you pull it out.
These retirement accounts are also known as tax-deferred accounts, which means you aren't responsible for a tax bill every year stemming from any potential interest or dividends, or capital gains incurred inside them. Therefore, again, there is nothing to manage tax-wise. Tax loss harvesting is one of those low-hanging fruit in the investment world or the financial planning world, a free lunch, if you will. But only if you are experienced and know how to use it appropriately. So that's what I'm gonna be talking about today.
So let's get started with what exactly is tax gain and lost harvesting. Essentially loss harvesting means to sell an asset or a security, such as a stock, at a loss. This, in turn, produces a realized loss for tax purposes and is commonly done purposely in order to help offset what is called a capital gain.
Capital gains are gains that are realized on a capital asset, such as an investible security, like a stock, or even real estate. Now, these gains can either partially or completely be offset by capital losses. In fact, you can even have what's called a net capital loss, which is when your total losses exceed your total gains.
You realize a capital gain by selling your capital asset for more than what you paid for it. Which then results in a tax liability on the profit you make in the year you dispose of it. Again, this wouldn't apply in a retirement account. So just forget retirement accounts from your vocabulary when it comes to capital gains and harvesting.
So you might be thinking if I don't sell anything at a gain in any particular year, I won't have any capital gains. And yes, you would be correct for the most part. Now the reason I say that is because there are certain investment vehicles, such as mutual funds, that often produce what are called capital gains distributions.
In short, these are capital gains generated by the fund itself without you personally actually triggering any gain by making a decision or a transaction to sell something. In other words, the mutual fund company is managing the investment for you and may make these transactions within their fund. And if they incur a gain at any time during a given year, that gain is then required to be passed along to you, the end investor.
Now, there are some other types of investments, typically real estate-related, that may produce a capital gain that also isn't necessarily triggered by you. But those are beyond the scope of this discussion. Just know that they exist, and they're typically owned by really savvy and accredited investors. Mutual funds aren't the only ones out there per se.
Now let's talk about the other end of the coin here. Gain harvesting, on the other hand, doesn't get as much love. And this is mainly due to the misconception that harvesting gains and therefore realizing taxes today is always a bad idea, which just isn't true. Gain harvesting is just that. This is where you intentionally sell some or all of a capital asset at a gain resulting in a taxable capital gain in the year you sell the asset. Again, like a stock or real estate, for example.
Capital gains and losses essentially work against each other or offset each other. And at the end of the taxable year, which is December 31st, you will either have a net capital gain or a net capital loss, depending on your overall activity throughout the entire year and across all of your taxable capital assets.
That is a key thing to remember. All of your taxable capital assets. So all of those taxable investment accounts and real estate as well. This means, for example, that if this year you sold an investment property at a gain and sold some securities at a gain as well in your trust account, for example, those two capital gains will both attribute to your overall capital gains for the year. You could have five different non-retirement accounts. With annual gain or loss activity. It doesn't matter. Everything gets netted together come tax time.
Now, when it comes to capital gains and losses, there are also a couple different types, and they are treated differently for tax purposes. And that is, you can have either a long-term capital gain or loss or a short-term capital gain or loss.
Generally speaking, long-term simply means the investment was held longer than twelve months before it was sold. And short-term is anything sold before twelve months since the date of purchase. Long-term gains are taxed at a more favorable or preferential tax rate. And short-term gains are taxed as ordinary income, which is typically taxed at a higher rate.
Ordinary income rates are the ones you're used to seeing and hearing about, such as when you're tax preparer or online tax prep software tells you that you are in the 22% or 24% tax bracket, for example. And I actually go into this in far more detail in a blog post all about capital gains, which I will actually provide you in the episode show notes.
Also, please note, we are only referencing federal capital gains taxes in this episode. Depending on your state of residence, you may be subject to taxes on your capital gains at the state level as well, which may also be treated as ordinary income. So please check with your tax professional on your specific situation.
So when would you want to harvest losses? Well, maybe something is going on in the world that has caused “all boats to sink,” for lack of a better term. I would consider these unicorn opportunities. A perfect example of an opportunity like this was when the news of COVID-19 settled in, and the overall stock market dropped around 30% from February to the end of March 2020.
In a scenario like this, nearly every sector or area of the stock market can fall in tandem due to the extreme shock and emotionally driven market movements by millions of investors. For example, healthcare company stocks may fall 30% in line with, say, microchip stocks, even if they fundamentally shouldn’t. Therefore, when the markets get past the short-term panic, oftentimes there can be significant rebounds in stock prices in virtually every sector of the market. In other words, at some point, if all boats have sunk, at some point, all boats may rise. During or after the initial shock to the market, there can be a small window of opportunity to realize some losses and reinvest in another sector of the markets at these still-depressed prices.
In that case, you could realize a loss for tax purposes and immediately reinvest. And then you would be ready for a potential market rebound. Now selling one type of stock or specific sector investment and getting into a completely different one is one tactic used to help avoid what's called the wash sale rules. We'll get more on that in a minute.
This COVID example brings up another important lesson. And that is don't just wait until year-end to pull out the loss harvest tool. Oftentimes the window of opportunity is small and should be taken advantage of quickly or even at multiple times during a given year. This is because you won't know yet whether or not that window of opportunity is a matter of days, three weeks, or even fifteen months, for example. You won't know until it's already passed and it's too late. In 2020, the markets actually rebounded significantly in a very short period of time, a matter of a few months. In that scenario, if you waited until year-end to try and implement, you would've likely had no losses to realize because the markets came back by then this is something you have to stay on top of if you're going to do it right.
Now I wanna pause for a moment to make something very clear. Please, please do not make the decision to sell an investment just because at the given moment, your investment is worth less than what you bought it for, and you can get a loss for tax purposes. You may very well have a great investment that is currently at a loss but still makes complete sense to have in your long-term investment portfolio. Holding out on the investment may very well benefit you far and above the tax savings you can realize by selling it today. This is why tax gain and loss harvesting has to be done right and not willy-nilly.
Now, when you buy an investment or build a portfolio, it should have a purpose. You should have a reason as to why you own what you own and truly understand that reason. This can help you gauge whether or not you should actually buy or sell something.
Now let's touch on those wash sale rules that I just briefly mentioned. One of the IRS rules that you need to be mindful of when doing the loss harvesting is the wash sale rule. Now, this rule prevents investors essentially from selling a security at a loss and then immediately buying back the same or a substantially similar security, just for the sake of getting losses for tax purposes. Basically, it just means you need to be more careful and get a little creative if you're going to want to reinvest your proceeds right away.
Now, per the IRS, the wash sale rule states that the tax loss will be disallowed if you buy the same security, a contract, or option to buy the security or a substantially identical security within thirty days before or after the date you sold the investment that generated the loss. So that means you can sell the investment, sit in cash, then reinvest in the exact same investment if you wanted after the entire waiting period.
Alternatively, if you reinvest immediately by buying a security that is not substantially identical, then this wait period doesn't apply. That's where you can get creative. But again, what you buy needs to have a purpose behind it. I wouldn't go randomly investing in different things.
Here's a couple important caveats to the wash sale rules in case you try to get too clever with this one.
One is that you can't have one spouse do a cell transaction of a security in their account and the other spouse make the purchase of a substantially similar security in their own account. I know it's clever, but no Bueno. The other common mistake gets investors caught slipping all the time in practice, and that is that you can't go buy a substantially similar security in your retirement account, such as an IRA, within that sixty-one-day window either. Now this one gets a lot of people by surprise because they go and make trades in their non-retirement account, and then they end up rebalancing a retirement within that time period and completely forget about the transactions they made, you know, earlier that day or within a month or two.
The wash sale rule covers all accounts. Be aware of that, especially if you invest online with what are commonly referred to as robo advisors and the like. They aren't humans, they don't know, nor do they care what goes on in your other accounts. This is also one of the many reasons why you shouldn't have multiple financial advisors that manage your money either. Why voluntarily create what's likely to become a communication issue at some point that will ultimately hurt you. Choosing one to implement your investment strategies is likely to be the most efficient.
So when would you want to harvest gains? Well, as I mentioned before, harvesting gains doesn't get much TLC, but can also be extremely beneficial. There can be several reasons to gain harvest. But I believe the most beneficial use of this tool is for tax arbitrage. That's just a fancy phrase for taking advantage of lower tax rates when you have the opportunity to do so.
Before I get into an example, I want to give you a brief overview of how long-term capital gains are actually taxed. Long-term capital gains currently have their own preferential tax rates, like I mentioned earlier, of either 0%, 15%, or 20% for the highest of income earners out there. In addition, an individual may be subject to a Medicare surtax, which is called the net investment income tax, which is 3.8%.
So all in, at the federal level, the highest long-term capital gain rate is currently 23.8%. Even at the highest rate, though, this is still better than some of the ordinary federal income tax rates, which quickly reach 24% or more. That being said, long-term capital gains also have their own brackets or income ranges to determine which of those rates you will pay on your long-term capital gains.
Kind of like the ordinary income tax tables or ranges you may be used to seeing. For example, in 2022, the 0% capital gains bracket goes from a single dollar up to $41,765 in taxable income if you file single. And it goes from $1 to $83,350 if married, filing joint. Again these long-term capital gains brackets or ranges are different than the ones for your other ordinary income, such as your income from a W2 job or self-employment.
By the way, I have included a helpful 2022 tax sheet in this episode show notes or on our website that you can reference for your own situation. It will give you all of the different income and capital gains tables, ranges, and rates for 2022. We also update these every year, and are available to our newsletter subscribers.
So now you're probably thinking like, wait, what did you say 0%? Yes, that's right. But before you get too excited about paying 0% on your capital gains, you need to be aware of this very important caveat that most people, even a lot of professionals, don't understand. And that is that your long-term capital gains are stacked on top of your other income when determining the capital gains bracket or range that you fall into.
For example, if you have in 2022, let's say $80,000 in taxable income from your W2 wages. So, again, this isn't gross income or adjusted gross income, but this is actually taxable income. And that's your income after you get several deductions. $80,000 in taxable income in 2022, and then you have a $10,000 capital gain in addition. What you would do is you would look for the capital gains bracket that includes $90,000 in taxable income. In this case, that would actually put you in the 15% capital gains bracket, which is still not too bad. Imagine, however, having a well-constructed financial plan that allowed you to plan for a time to realize some of your capital gains when you may be in the 0% bracket. Then you could use some of that tax arbitrage I was talking about.
Yes, it is definitely possible to be in the 0% capital gains bracket. Let's do another example. Let's say the first or second year of retirement, you bring in $50,000 of taxable income as a married couple. Again, this is taxable income. So your actual take home could still be much higher than this. That would be your gross income, especially if a good chunk of your income is from social security, for example.
In this case, with the 2022 figures, you theoretically have about $33,000 of room in capital gains to realize and pay nothing on that gain. You could “fill the bracket” or the tax bracket range.
This is again because the 0% rate goes from a dollar to $83,350 for a married couple filing jointly. You could then turn around with your investment proceeds and reinvest as you please or not. The wash sale rules don't apply to gains. If you were to reinvest, let's say, in the same or similar investment, this strategy could increase your cost basis in that investment as well.
Now, what is cost basis? Really all it is is your original purchase price or your investments starting point. It's what you paid plus any fees or anything like that. And this will reduce any future potential taxable gains if you need to sell some of that same investment again at some point in the future. When talking about tax arbitrage, I want to note that depending on your situation, it may be more beneficial to “fill the bracket” with any ordinary income sources before looking to realize capital gains.
Now, this is because ordinary income rates are typically higher. So if you find yourself in a situation where you have low taxable income, you may want to try and save tax dollars on those other income sources first. A good example of this is accelerating some spending, maybe from an IRA or a 401k. These nuances are why financial planning is so critical.
So as you can see, capital gain harvesting can be a very beneficial tool to have in your retirement tool chest, but it only helps if you know how to use it properly. Now, does it ever make sense to do them both at the same time in the same year? Absolutely. Here's another example. Let's say your non-retirement accounts contain some investments in oil industry stocks or other securities, and also, you have one lousy-performing popular internet stock you bought a couple years ago when you thought you knew how to pick stocks. I would use stocks to keep it simple in this example.
The oil industry stocks have skyrocketed this year, far and above what you originally paid for them, and your internet-based stock has been absolutely decimated this year. So much so that the shares are worth far less than what you originally paid for them. Therefore your oil industry stocks now make up a large portion of your portfolio, say 15 to 20%.
Now being smart, you realize that this has become too large of a position in your portfolio and carries incremental risk. So naturally, you want to sell some of it and bring the allocation back down to earth. This would require selling at a gain and therefore incurring a long-term capital gain. Remember, in this example, you bought them a couple years ago, which is more than twelve months. At the same time, you realize you probably shouldn't hold onto that lousy company stock in hopes that one day it will come back to the value that you paid for it.
This is where we can turn to tax loss harvesting to help mitigate the tax burden. You could theoretically look to sell some or all of your internet stock in order to realize a capital loss that can partially, or maybe even fully offset the gains you incur from the other sales. Not only that, but you would also have a specific purpose for realizing the gain and the loss by bringing your asset allocation back in line and getting rid of that investment you probably never should have purchased in the first place. So you see, sometimes there's a silver lining.
Now I want to take some time to talk about long term losses. If your total losses you incur in a given year are greater than your total gains, the resulting net loss can offset up to $3,000 of your ordinary income. This is unless you file taxes married, filing separately, which is rare, but I do see it from time to time, in which case the limit is only $1,500.
This means that up to $3,000 in losses can actually offset other income you receive from, say, a job or self-employment income. This can be a huge benefit as it can save you whatever your marginal ordinary income tax rate is versus saving you on the lower capital gains rates, such as saving you 24% instead of 15% for example. Plus, if you still have losses left beyond the extra $3,000, that additional loss amount can be carried forward to offset capital gains in future years until it's all used up.
Let's put this all together in an example, let's say you sell multiple stocks in your trust account for a long-term capital gain of $10,000. You also sell some other stocks in your trust account at a $5,000 long-term loss. In addition, you sell some bonds and yet another investment account you have at a $25,000 long-term loss. That's $30,000 in total losses. The result is that the $10,000 in long-term gains are first offset by $10,000 of the long-term losses.
Then the remaining $20,000 in losses are able to be carried forward to offset potential long-term capital gains in the future until it is all used up. Remember, you can use up to $3,000 of those losses to offset this year's ordinary income as well. So if let's say you have $100,000 of other income from a job, you would get a $3,000 deduction, which would theoretically make it $97,000 that's subject to taxation. Now you have $17,000 in capital losses left in your bucket to carry forward into future years. It's almost like having your cake and eating it too. Then let's say the following year, you have no capital gains to offset. In this case, you are able to use another $3,000 of your $17,000 bucket of losses to help offset your ordinary income again, leaving you with a new balance of $14,000 to continue carrying forward. I think you get the picture.
The bottom line is that tax loss harvesting can be extremely beneficial in mitigating your tax bill if you have savings beyond the traditional retirement accounts. I want you to realize that by reducing taxes over your entire lifetime, you can keep more of your hard-earned money in your pocket and not the IRS's, and therefore it can help you increase your net worth over time. And that's what we're all about here on Retired-ish.
If you would like to learn more about these rules discussed and want to find more information to help you retire on your terms, you can find links to the resources we have provided in the show notes on your podcast app, or you can visit us at retiredishpodcast.com/2. Again, that's retiredishpodcast.com/2.
Thank you for tuning in and following along. As always, see you next time on Retired-ish.
Securities and advisory services are offered through LPL Financial, a registered investment advisor, member of FINRA SIPC.
The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
This information has not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.