MICHAEL KITCES for the Wall St Journal writes: Since 2008, those taxpayers whose income falls within the bottom two tax brackets–up to $36,900 of taxable income for individuals, or $73,800 for married couples–are eligible for a 0% federal tax rate on long-term capital gains. However, the rate only applies to income that actually falls within the bottom two brackets–once income rises over $36,900 for individuals ($73,800 for married couples), capital gains are once again taxed at 15% (ultimately rising to a rate as high as 23.8% at top income levels). On the one hand, this favorable rule allows lower-income individuals to avoid taxation on their long-term capital gains (and qualified dividends). Yet on the other hand, for those whose income may just be “temporarily” low due to any number of life circumstances (from unemployment to a bad business year to retirement itself), being in the bottom two tax brackets–and eligible for the associated 0% federal tax rate on long-term capital gains–is a limited-time opportunity to take advantage of, by deliberately harvesting capital gains.
The good news is that while it can be a bit of a nuisance to harvest capital losses–due tothe 30-day “wash sale” rules, which creates a loss harvesting risk that the investment will have materially changed in value in the meantime–it’s rather easy to harvest a capital gain. Sell the investment that’s up in value, and buy it back again. If it’s a mutual fund, it can be done on consecutive days. If it’s a stock or ETF, you may only be out of the market for minutes or even just mere seconds! Congress does not have a rule that says “Oh, you sold the investment, but since you bought it back again you don’t have to pay your taxes.” You do. Except for those in the lower tax brackets, this can actually be great tax planning.
Imagine an investor who has an ETF that was purchased for $10,000, and it is now up to $18,000 in value, an 80% gain thanks to the great run in the stock market in recent years. The investor sells the ETF for $18,000, and buys it back again immediately for $18,000. As a result of this transaction, the cost basis of the investment will be increased from the original $10,000 to its “new” purchase price of $18,000, and the investor will face an $8,000 long-term capital gain. Except if the investor is in the bottom two tax brackets, the federal tax rate on the gain is 0%, and the step-up in basis—which, in turn, reduces the magnitude of any future capital gains and saves money down the road as well–is free!
Of course, the reality is that the cost of harvesting a long-term capital gain isn’t always a perfectly free $0 impact. There may be some transaction costs to consider (from trading fees to bid/ask spreads), some people may face a small state income-tax liability, and although the capital gains rate is 0%, it is still income and as a result can impact other income-related tax calculations (from phasing out the premium assistance tax creditto the phase-in of taxation of Social Security benefits and more).
Nonetheless, in a world where the only other way to get a step-up in basis is to dieowning the investment, the opportunity to harvest long-term capital gains at a near-$0 cost is highly appealing. But since it only works to the extent that the taxpayer’s income–including the capital gain itself–stays within the bottom two tax brackets, it is a limited opportunity that both caps out each year and vanishes if it is unused. So if you ever find yourself in the bottom tax brackets while holding investments that are up in value, don’t let the opportunity go to waste–make sure you harvest those 0% capital gains, at least to the extent you can!
Michael Kitces is a Partner and the Director of Research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd’s Eye View. You can follow him on Twitter at @MichaelKitces, or connect with him on Google+.
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