You may be familiar with the term “tax loss harvesting.” Toward the end of each year, many investors routinely sell assets such as stocks or mutual funds with embedded losses to offset the current taxes they will have to pay on gains from other assets.
This strategy generally works well during periods of steady or declining tax rates. However, if you really wanted to keep those stocks or funds and sold them solely for the purpose of taking tax losses, you would need to buy them back immediately after selling them.
The IRS doesn’t appreciate investors executing this maneuver for the sole purpose of deferring taxes. So they require you to wait 31 days or more before repurchasing the asset (or a substantially identical asset), otherwise they will add the loss to your cost basis and treat the sale as if it never happened. This is the wash sale rule and complying with it can make this strategy a bit tricky to execute.
This year we are facing the so-called fiscal cliff. Among other things, the 15 percent long-term capital gains tax rate has the potential to increase to 20 percent if Congress fails to restore some or all of the tax cuts set to expire Dec. 31. In addition, married taxpayers with incomes more than $250,000 will see their capital-gains tax rate go up an additional 3.8 percent to fund the Affordable Care Act (this one is a sure thing). Under these circumstances, tax loss harvesting probably doesn’t make sense. But you can do the reverse (tax gain harvesting), and it’s completely acceptable to the IRS.
The strategy involves selling assets with embedded long-term gains before the end of 2012, then immediately buying them back. The gains accumulated since the assets were originally purchased will be taxed this year at the current 15 percent rate, and any future gains will be taxed at the higher 2013 rates. Not only is this strategy simple to execute, it does not run afoul of the wash sale rule, because that applies only to losses, not gains. (The IRS is perfectly happy when you make your tax payments sooner rather than later.)
It’s important to remember that this strategy applies only to investments held in taxable accounts, not in retirement accounts like IRAs or 401(k)s. Because the money you put into the latter accounts was never taxed (except under certain circumstances), the IRS doesn’t care how much you paid for your investments. You will be taxed at the ordinary tax rates when retirement account money is withdrawn.
If you are a high-income taxpayer, tax gain harvesting in 2012 could save you at least 3.8 percent in taxes on your investments, unless tax rates go down within the next five years or so (a pretty unlikely prospect). For everyone else, you need to balance your expectations of higher tax rates – what are the odds that our lawmakers will reach a deal before the end of the year? – with your own cash-flow needs for this year and next. Don’t wait too long before having this conversation with your tax accountant or financial planner.
Los Altos resident Artie Green is a Certified Financial Planner with Cognizant Wealth Advisors. For more information, call 209-4062.