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.
To do this, 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 a profit after you've owned the investment for more than 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. Most people pay a capital gains rate of 15%, but those who earn less than $40,400 in the 2021 tax year ($80,800 if married filing jointly) won't pay any taxes on long-term capital gains.
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, so the exact rate will depend on your income and tax bracket.
How Capital Losses Can Help
Capital losses, as the name suggests, occur when you sell an investment at a loss instead of a profit. 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 to offset income in future tax years.
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 realize as many long-term capital gains as possible—up until the point when more gains would push you into a higher tax bracket (causing the 15% capital gains rate to kick in). 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 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—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, 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 (like bonds and bond funds) inside your retirement accounts and more capital gains-producing (like stocks and stock-index funds) investments inside 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.