How to Harvest Capital Losses or Gains to Save on Taxes
A Guide to Managing Capital Gains for Investors
Investors who own stocks or mutual funds in non-retirement accounts can benefit tax-wise from realizing capital gains or harvesting losses in a given year. Managing capital gains and losses can reduce the amount of cumulative taxes you'll pay, increasing your after-tax returns and, in many cases, allowing you to realize tax-free gains.
But you have to know how capital gains taxes work, and you have to be able to estimate your taxable income each year. Managing capital gains means looking for years where it makes sense to intentionally “harvest” gains or losses depending on your projected tax bracket for that year. Harvesting means pretty much what it sounds like—you're gathering up your gains and/or losses to use them at a time when it's most advantageous for you to do so.
Short-Term vs. Long-Term Capital Gains
Capital gains are either short term or long term. Long-term gains occur if you sell an investment for more than you paid for it after you've owned the investment for at least one year. Long-term capital gains and qualified dividends are taxed at a lower tax rate than other types of income, such as earned income or interest income. For those in a 15-percent or lower tax bracket, long-term gains have a zero percent tax rate as of 2017.
Short-term gains are profits realized on the sale of an asset you've owned for less than a year; these are taxed as regular income, which is typically a much higher tax rate.
How Capital Losses Can Help
Capital losses occur when you sell an investment for less than your investment in it. Capital losses are first used to offset any short-term gains on your tax return, then they can offset any long-term gains you might have. Up to $3,000 of a loss can be used to offset ordinary income if you have more losses than gains, and any remaining losses can be carried forward indefinitely to be used in future years.
Using the Rules to Your Advantage
In years where you'll be in a 15-percent or lower tax bracket, and if you have no capital loss to carry forward, you'll want to intentionally realize just enough long-term capital gains to fill your income up to the top of the 15-percent tax bracket. This is called “harvesting” capital gains.
In years where your income is high and you have no capital loss to carry forward, and if you've realized no gains, you can intentionally sell investments that may be down in value so you can realize the capital loss for tax reasons.
If you have capital losses that are being carried forward, you might want to avoid realizing gains and use those capital losses to gradually offset ordinary income—your earnings. This means you'll have to choose tax-efficient investments in your non-retirement accounts. Your best choices will be tax managed funds or index funds.
Protect Your Retirement Income
You'll have to know the current tax rates to use these rules, and you'll want to do a tax projection each year before the end of the year so you know where you stand and what you need to do. A tax projection is a rough-draft tax return that estimates everything you think will show up on your tax return.
By using an investment approach that consistently pays attention to taxes, you can potentially keep more of what you earn and thus increase your after-tax retirement income. One possible way to do this is to rearrange investments in such a way that you own more interest income-producing investments inside your retirement accounts, like bonds and bond funds, and more capital gains-producing investments inside non-retirement accounts, like stocks and stock-index funds.