Harvesting free long term capital gains

In the Get FI article I list minimizing taxes as a means to speed up the time to financial independence. One mechanism to minimize taxes is to harvest free long term capital gains. In 2016 if you were in the 15% tax bracket you could harvest long term capital gains and pay zero in taxes. How cool is that? For a married couple filing jointly in 2016 the 15% bracket was $75,300. Note that if you are reducing your income by contributing to a 403b, a 457, an HSA and traditional IRAs, a married couple may be able to get to the 15% tax bracket even with a six figure income.

How does harvesting gains work?

Let’s say you had bought Vanguard Total Stock Market (VTSAX) for $20,000 in 2014. In 2016 if it was hypothetically worth $30,000 you would have a basis of $20,000 and $10,000 in unrealized long term (> 1 year) capital gains. If you don’t ‘harvest’ then at some point you may have to pay taxes on your gains. By harvesting the gains you can reset your basis higher, thus potentially lowering future taxes. If after selling the fund and harvesting the $10,000 (which counts towards your income) you are still in the 15% tax bracket, you get a ‘step up in basis’ for free.

Why is it important to harvest free gains?

If you increase the cost basis of the mutual funds in your taxable account by harvesting gains, when you ultimately sell them in the future, you may lower your tax. Free money is good. Also if they lose money after you increase the basis and you sell them in a later tax year, you can harvest a tax loss. After you retire early, you might use a harvested loss to increase the amount you convert from a traditional IRA to a Roth by up to $3,000.

How I messed up in 2016

I have a confession. I didn’t take full advantage in 2016. It turns out I could have harvested an additional $12,000 in gains… I didn’t understand that standard deductions can increase your harvest because of how your income ‘stacks’. Michael Kitces explains the mechanics here. Since 2016 has come and gone it’s too late for me to sell and harvest for 2016. However I went back to my 2016 return and manually changed a long term capital gain in TaxAct software and found out I could have harvested another $12,000 in gains before my income tax increased. Oops.

There are caveats
  • You only get the free harvest on long term capital gains (held longer than one year), not on short term gains.
  • The gains you harvest count towards your income, and thus affect how much you can harvest for free.
  • Harvesting capital gains can impact state taxes. Since I live in Washington State which has no state income tax, that doesn’t affect me.
  • If you buy a different mutual fund like I did after you harvest your gain you may realize an unqualified dividend on the new fund you buy, that you have to pay taxes on. Thus if you’re going to sell and buy a different fund, avoid buying within 61 days of a dividend distribution so that the dividend is qualified. For Vanguard funds that pay dividends quarterly that means you can harvest a few days after the distribution and buy the other fund more than 61 days before its distribution date. For example in 2016 Vanguard Total Stock Market Admiral Shares (VTSAX) and Vanguard S&P500 (VFIAX) had their distributions on Sept. 9th. Using the example above one could have sold $30,000 of VTSAX shares that were long term with a basis of $20,000 on Sept 12th, 2016 and bought $30,000 of VFIAX thus harvesting $10,000 in capital gains. The next distribution date for VFIAX was December 20th, 2016 so the dividends from the new purchase would be qualified if you held the fund for more than 61 days. I realize that VTSAX and VFIAX are not equivalent, but they track so closely that for me, I am comfortable holding either.
  • This is a big one. Harvesting long term capital gains interacts with other income events such as a Roth conversion or dividends, so make sure you understand the big picture. For 2017 I used tax software to estimate how much I can harvest for free, rather than trying to calculate it by hand.
  • You have to harvest within the tax year. You cannot wait till the next year after you know your exact income to find out exactly how much you can harvest.
  • If you purchase health insurance using the ACA (Obamacare), harvesting gains can increase your income and therefore decrease subsidies.
Moving forward to 2017 harvesting

For 2017 I modeled my expected income and predicted the maximum capital gains that I could harvest for free using the 2016 version of TaxAct Plus. Based on this modeling I have already harvested long term capital gains for 2017. When I do my 2017 income taxes in early 2018 I will know my exact income and see how close I came to maxing out my harvest of free long term capital gains. But I will definitely have done better than 2016 where I left $12,000 on the table. As you can see from my 2016 mess up I am no tax expert, so consult a tax professional for your situation.

harvesting capital gains
Harvesting garlic is easier than harvesting capital gains, but it’s not as lucrative

Trip to Waimanalo, Oahu

Trip to Waimanalo, HI
Waimanalo Beach

This is a one week trip where we stayed at a vacation rental in Waimanalo, Oahu. We used credit card points to cover the flights (Spokane to Honolulu) and the rental car. Waimanalo beach is spectacular with light colored sand and azure/coral blue water. Overall Oahu was a pleasant surprise, as for some reason I had expected the most populous island to be less beautiful than Kauai where we had visited previously. Instead I found the landscape stunning, and we were treated very well by the locals.

Planning the flights

We wanted to use points which required booking well in advance, almost a year. But I’ve found it’s often difficult to find convenient Round trip flights using points. But if you only look one way you can often find convenient flights using one program to get there, and a different one to return. We found convenient flights to Honolulu using 20,000 Delta Skymiles points per person and convenient flights returning to Spokane using 15,000 Flying Blue points per person. Once I had found the flights I moved Citi ‘Thank you’ points to my Flying Blue account which posted immediately and then purchased the flights. The Delta points came from an Amex gold card. In total we used 70,000 points for two people. To me there is no problem having flights there and back on different reservations/different airlines. But I like to book both passengers (DW and I) using the same program on same reservation so we can easily arrange seating together, and if the airline changes the reservation, both tickets are linked. The Flying Blue flights were actually on Delta, but we saved 5,000 points per person using Flying Blue points.

Planning where to stay

We had plans to meet up with a friend in Kaneohe while we were there so we knew we wanted to stay relatively close. We wanted a place that we could walk to a non-crowded beach and also walk to eateries. I looked at vacation rentals on VRBO and found a two bedroom cottage that cost $1,740 for a week inclusive that was a 5 minute walk to Waimanalo beach and a ~20 minute drive to our friends place in Kaneohe. I always look for places where we do not share a wall (or floor/ceiling) with others as I relish peace and quiet.

The rental car

For the rental car I used Chase ‘Ultimate Rewards’ (UR) points. DW and I had generated 100,000 UR points by each getting a Chase Sapphire Preferred card (50k UR points). I moved the points to our new Chase Sapphire Reserve card which allows a 50% bonus when redeeming points. Total cost to rent a Ford Focus from National for a week from Honolulu airport: 15,946 UR points.

Getting to Oahu

We chose an early departure (5:45 am from Spokane) that got us into Honolulu at 11:40 am. This meant waking up at 2:45 am and leaving the house at 3:15am. I have gotten used to getting up early and really prefer it now as I like to get to the destination earlier. The flight to Seattle was on an Embraer 175 which had 2+2 seating and is a jet which DW prefers over a turboprop. Nice start, in the future I will specifically look for Embraer 175 flights. Our connection was at Sea-Tac and we were able to use our Priority Pass that comes with the Chase Sapphire Reserve credit card (you have to request it) to access the ‘The Club at SEA’ lounge in the South Satellite where our departure gate was. A tasty coffee, and toasted bagel in a quiet uncrowded setting, and a bottled water for the flight and then we were on our way. We arrive on time and make our way to the National car rental booth. I videotape the car with the mileage to go over the dings and dents before we leave the lot and we are on our way.

Honolulu to Kaneohe

DW and I are both tired from the flight and ready for lunch. We drive to Kaneohe and after  two miss-steps find ‘Kenko Ya’ Japanese restaurant. It’s ~3/4 full, a good sign and we are seated. I order the special that comes with edamame, sprouts, miso soup, and two choices where I pick sashimi and shrimp tempura. DW gets a soft shell crab roll. Food is great, particularly sashimi which is fresh and we decide we will be back. A nice touch is one of the older servers (an owner?) motions us to a nicer table when it opens up. I really appreciate it when restaurant staff make an effort to improve the experience of an obvious tourist. I am beginning to really like Oahu. The Safeway is in the same outdoor Mall across from the restaurant, and we get supplies for the trip.

Kaneohe to Waimanalo

Back on the road there is some highway construction, but we make it to Waimanalo with only about 10 minute traffic delay. Ironically our vacation rental landlords have already stocked the rental with very similar food to what we bought at Safeway (bananas, milk, bread). The rental is in a neighborhood and my first take is not good. People are parking on their lawns and some young men next door with bandanas on makes me think we may be in for some loud music. As I write this two days in, the neighbors have actually been very quiet, so my fears were unfounded. After we relax we head to the beach using a public access trail and it is … spectacular.

Waimanalo beach
Trip to Waimanalo, Oahu
Waimanalo beach with view of Manana island

The views of Manana (Rabbit) Island with the coral blue ocean are stunning. There are a few groups of people boogie-boarding but plenty of space on a Wednesday. This is probably the most visually spectacular beach I’ve ever been to. After a walk down the beach we go to ‘Ono steaks’ to get take-out dinner. DW and I get the $9.50 combo of shrimp plus 4 oz. steaks with rice and salad. Back at the cottage it goes great with ice cold Kirin Ichiban beer. Later in the visit I do some body boarding.

Pearl Harbor

To get tickets to visit the USS Arizona we logged into the reservation site at 7 am the day before we wanted to go. I quickly reserved 3 tickets. We arrived, picked up our tickets, and had 30 minutes to stroll and read about the contributions of individual submarines and their crews. Ten minutes before our time we entered the line to the movie. I learn the air defense was concerned about sabotage so they parked the planes defending Pearl Harbor wingtip to wingtip without any ammunition. We take the boat ride out to the memorial and learn that survivors from the USS Arizona are being interred with their shipmates, as recently as 2017. After the Arizona tour we paid for a tour of the USS Bowfin submarine and take the audio tour. I really enjoyed it and was amazed by the complexity of the electrical power of the sub.

Bowfin submarine
Bowfin submarine
Bowfin submarine tourist attraction
Bowfin submarine controls

We had several great meals. The first was at Kenko Ya. On the second visit I got the combination meal again with butterfish and shrimp and vegetable tempura which was excellent. The most fun we had was Haleiwa Joe’s in Haiku Gardens near Kaneohe. When they brought the prime rib to the table next to us we were in shock at it’s size, huge. When it came to our table it tasted great, but there was no way I could eat it all. So DW and friend get ¼ of my prime rib and share their fish so we all end up having surf and turf. The view of the Ko’olau Mountains from the deck is spectacular, really an amazing evening.

Dining at Haliwei Joe’s in Haiku Gardens

We had a great time and enjoyed staying near Waimanalo beach. Living in the country doesn’t mean you can’t get off the farm and do something new. Credit card rewards can help minimize the cost, and keep you on track for FI. We will be back.