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.