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Understanding How Tax Gain Harvesting Works

SmartAsset: Understanding How Tax Gain Harvesting Works

SmartAsset: Understanding How Tax Gain Harvesting Works

Most investors are familiar with the concept of “tax-loss harvesting,” which allows you to harvest your losses when an investment has lost money. But, did you know that you can harvest gains as well? When used strategically, tax gain harvesting can save money, reduce taxes, and lower your portfolio’s risk. Let’s break down how it works.

A financial advisor could help you put together a tax strategy for your investment needs and goals.

What Is Tax Gain Harvesting?

Tax gain harvesting is the strategic selling of assets that have increased in value to minimize taxes and return balance to your portfolio. The common wisdom is to hold off on selling appreciated assets to avoid paying capital gains taxes. However, this isn’t always the best approach because it can lead to over-concentration within your portfolio, which increases the risk of future losses.

How Does Tax Gain Harvesting Work?

There are several reasons why you should sell appreciated assets. Below are three scenarios when it makes sense sell and harvest your gains to improve your portfolio’s overall financial health.

Lower tax bracket this year. For people whose income varies from year-to-year, locking in your gains during down years is a good idea. You can take advantage of lower tax brackets to keep your tax bill low. Plus, your capital gains tax rate may be as low as 0% if your taxable income is below $40,400 as a single taxpayer ($80,800 married filing jointly) in 2021.

Offset losses in your portfolio. If you have losses in your portfolio, you can offset the gains you’re harvesting dollar-for-dollar. This tax loss harvesting strategy is one that many investors are familiar with. You can harvest your losses at any time during the year, but most investors wait until year-end to harvest gains based on their accumulated losses and tax situation.

Reduce concentrated positions (AKA rebalance your portfolio). Investors typically have an ideal mix of stocks and bonds for their portfolios. Based on market performance, your portfolio mix could use rebalancing. Rebalancing is the act of selling appreciated assets and buying those that have lost money to regain the proper mix. This keeps you from becoming too concentrated in one asset class and allows you to buy assets that are “on-sale” from the usual value.

When You Shouldn’t Use Tax Gain Harvesting

SmartAsset: Understanding How Tax Gain Harvesting Works

SmartAsset: Understanding How Tax Gain Harvesting Works

Tax gain harvesting is an excellent strategy in the right situation, but not all investors should take advantage of it. In some instances, following this approach can actually harm your financial strength. Here are three situations when you shouldn’t use tax gain harvesting.

You held assets for less than a year. Tax gain harvesting takes advantage of the low tax rates for long-term capital gains. In order to qualify for these lower taxes, you must own the asset for at least one year. If you sell it before one year, ordinary income tax rates apply.

You may owe Alternative Minimum Tax (AMT). The AMT is an alternative tax calculation required by law for some taxpayers. Depending on your income, selling investments to harvest gains could cause you to owe an alternative minimum tax. Before harvesting your gains, consult with your tax advisor and consider preparing a preliminary tax return to see if the AMT applies to your situation.

You have to pay Net Investment Income Tax (NIIT). The Net Investment Income Tax is an additional tax on high-earning taxpayers must pay on certain net investment income. If this tax applies, you’ll pay an extra 3.8% in taxes on investment income above the threshold. For single filers, the threshold is $200,000, while married filing jointly is $250,000 (2021 tax rules). These income limits are not indexed for inflation, so it’s possible that more and more investors will be subject to this additional tax in future years.

Consult with your tax advisor to see if you’re subject to the net investment income tax. If so, discuss how harvesting your investment gains may affect your taxes.

Bottom Line

SmartAsset: Understanding How Tax Gain Harvesting Works

SmartAsset: Understanding How Tax Gain Harvesting Works

Tax gain harvesting is the right approach for many investors to minimize future tax bills and to rebalance their portfolios. This strategy is typically implemented at the end of the year because you’ll have a clearer picture of your potential tax bill. Before making any decisions, it is best to work with your financial advisor and tax professional to understand how tax gain harvesting will impact your overall goals.

Tax Planning Tips for Your Portfolio

  • A financial advisor could help you figure out the potential tax implications of owning and trading cryptocurrency and what the extension of wash sale rules could mean for you. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • Our tax return calculator allows investors to project what their tax liability may be for their federal taxes. This is a valuable tool that you can use to determine how different actions may affect your taxes owed.

  • Financial advisors offer valuable advice when you’re considering tax gain harvesting. They can help identify ideal assets to sell and offer suggestions on where to reinvest the money to suit your financial goals. Use our advisor locator tool to find someone near you.

Photo credit:©iStock.com/Ridofranz, ©iStock.com/Inside Creative House, ©iStock.com/Natee Meepian

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