Harvesting an investment is the act of gathering any gains or losses you have taken at the right time so that you lower your taxes and losses, and max out your gains. When you manage your capital gains and losses, you can reduce the amount of total taxes you'll pay. Your total gains will then increase.
To do this, you have to know how capital gains taxes work. You'll also need to be able to estimate your taxable income each year. Managing your capital gains means looking for years where it makes sense to “harvest” gains or losses in relation to your projected tax bracket for that year.
- Harvesting capital gains is the process of claiming the money you've earned on investments in the most tax-advantaged way.
- You pay capital gains taxes on the interest you earn and realize on assets you've held for longer than one year.
- You pay income taxes on the interest you earn and realize on assets that you've held less than one year.
Short-Term vs. Long-Term Capital Gains
You pay capital gains taxes when you've owned an interest-earning investment for more than a year and sell it. When you sell that asset, you receive its total value at that time. If you've held it longer than one year and it is worth more than the money you've put into it, you have capital gains. If it is worth less than you've placed into it, you have a capital loss (also known as a recognized loss) regardless of how long you've held it.
Capital gains on an investment held less than one year are taxed as normal (earned) income and must be reported in your annual tax filing. This is where your current and future tax brackets come into play.
Long-term capital gains are taxed at a lower tax rate than earned income. Many people pay a capital gains rate no higher than 15% because of their annual earnings; those who earn less than $80,000 in the 2021 tax year won't pay any taxes on long-term capital gains. If your taxable income is between $80,001 and $441,450 per year and you're single, you'd pay a 15% tax on any capital gains ($496,600 if you're married and file jointly).
You can only carryover the lesser amount of $3,000 or your total net loss shown on line 21 of tax form Schedule D.
How Capital Losses Can Help
Up to $3,000 of a loss can be used to offset ordinary income if you have more losses than gains. You can carry any remaining losses forward to offset income in future tax years.
Capital losses occur when you sell an investment at a loss instead of a profit. You'd first claim the losses on your tax returns, which offset any short-term gains you claimed for that year. For instance, say you had a net capital loss of $4,000 and a $3,000 short-term capital gain in one year. You could claim a $3,000 loss that year and roll the remaining loss of $1,000 into the next tax year.
Rolling losses into the next year can offset any long-term gains you might have. If you rolled a $1,000 loss to the next year and made $5,000 in capital gains, you would only be taxed on $4,000 of that gain because of the loss from the previous year.
Using the Rules to Your Advantage
If your annual income level is low enough to qualify for the 0% tax rate on capital gains, you'll want to take as many long-term capital gains as possible—up until the point when more gains would push you into the higher 15% capital gains tax bracket. This is called “harvesting” capital gains.
In years where your income is high and you have no capital loss to carry forward, you can intentionally sell investments that may be down in value to realize the capital loss for tax reasons.
If you have capital losses to carry forward, you might want to avoid realizing the gains and use them to offset ordinary income over time—such as your wage earnings from employment. 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. You'll also want to make 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 appear on your tax return.
By using an investment approach that always pays attention to taxes, you can work to keep more of what you earn and increase your after-tax retirement income. One way you could do this is to rearrange your portfolio so that you own more assets that produce income (like bonds and bond funds) inside your retirement accounts. Then, allocate more that produce capital gains (like stocks and stock-index funds) inside your non-retirement accounts.
The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.