Monday, October 13, 2014

When to Tax-Gain Harvest Your Bonds

Mike Piper, the Oblivious Investor writes: Last week’s article about tax-gain harvesting with bonds  (below) drew quite a bit of correspondence from readers. (To recap, the general idea is to sell a bond that has increased in value since you bought it — and which you have held for more than one year – and reinvest the proceeds in a similar, newly-issued bond with a comparable remaining maturity. In doing so, you effectively convert some of the interest income into long-term capital gain income, which is often advantageous due to the fact that long-term capital gains are taxed at a lower rate than ordinary income.)
The primary question readers had was: Are there cases in which it would not make sense to use such a strategy?

And the answer is that, yes, there certainly are some cases in which it wouldn’t make sense to tax-gain harvest your bonds.

For example, the desirability of the strategy depends on what type of bond we’re talking about.
  • It is most likely to make sense with corporate bonds,
  • It is less likely to make sense with Treasury bonds, because the interest on Treasury debt is free from state income taxes, whereas the capital gain income would, in most cases, be taxable at the federal and state levels, and
  • It is almost never going to make sense with muni bonds, because muni bond interest is tax-exempt at the federal level, whereas the capital gain income would be taxable at the federal and state levels.
In addition, there’s the possibility that something else tax-related would make you want to avoid increasing your income this year. For example, if there’s a particular tax credit for which you currently just barely qualify, but the capital gain would push your income over the eligibility threshold, tax-gain harvesting this year is unlikely to be advantageous. Or, if you’re a retiree collecting Social Security, and your income level is currently at a point where your Social Security is nontaxable — but realizing a capital gain would push you into the range where a significant portion of your benefits would be taxable this year — that’s a point against tax-gain harvesting.

In general, the analysis that you want to do is figure out how big the tax increase would be this year (due to the capital gain income) and how big the savings would be in future years (due to the reduced level of interest income). To get the best analysis possible at a DIY level (i.e., without paying a professional to assess the situation for you), it probably makes sense to do a test-run through TurboTax (or something similar) comparing each approach (selling vs. holding) for the years in question.

Tax-Gain Harvesting with Bonds

Tax-loss harvesting is a very common tax strategy in which you sell a holding when its value is less than the amount you paid for it, then reinvest the proceeds from the sale in a similar (though not “substantially identical”) investment. The idea is that you then get to use the capital loss (up to $3,000 per year) to offset ordinary income on your tax return, without having to make any significant change to your portfolio.
Tax-gain harvesting is a somewhat less common strategy, as it’s generally only helpful for people in the 15% tax bracket or below. The idea is to sell a long-term holding for a gain, then reinvest the proceeds in a similar investment. The benefit comes from the fact that, if you’re in the 15% tax bracket or below, you do not have to pay any tax on the long-term capital gain, and now your cost basis in the asset has increased to the asset’s current value, thereby reducing the size of the capital gain that you might have to pay tax on in the future.
There is, however, a form of tax-gain harvesting that can be helpful even to investors who are in a tax bracket higher than 15%. It becomes relevant when you’ve held a bond for more than one year, and it is currently valued at a price higher than what you paid for it (i.e., the price has gone up because interest rates have fallen since you purchased the bond).
The idea is that, rather than holding the bond and continuing to receive payments at the bond’s higher-than-market interest rate, you sell your bond at a premium, then reinvest the proceeds in a bond that:
  • Has a similar credit quality and remaining maturity (so that you’re not changing the risk of your portfolio), yet
  • Is selling at (or very close to) its par value (e.g., because it’s a new bond).
By doing so, you essentially convert a portion of the yield that you would have received as interest into a long-term capital gain, which will be taxed at a lower rate than the interest income would have been. While it does result in having to pay the tax sooner than you otherwise would have had to (which is generally not a good thing), taking advantage of the difference in tax rates often allows you to achieve a higher after-tax return.