One opportunity that investors should never pass up is the ability to convert a taxable long-term capital gain into tax-free basis … without paying taxes to do so.
When Roth Conversions Are the Right Move – and When They Aren’t
This is known as harvesting long-term capital gains. It’s a process of intentionally selling an investment with a taxable long-term capital gain, in years whenever — due to your income — that gain will not be taxed. Then, if you want to keep the investment, you buy it back immediately.
The Income Sweet Spot to Make This Work
The gain won’t be taxed when it occurs in a year when the investor is in the “0%” long-term capital gain tax bracket, which for 2021 occurs when they have taxable incomes of $40,400 or less for singles, or $80,800 or less for married couples.
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The genius of doing this is that it increases the value of the investment that shows as the original amount invested, better known as the “cost basis” — which is always tax free — by the amount of the realized capital gain that was taxed at zero. Remember, because the cost basis in an investment is tax-free, the higher the cost basis, the less capital gains tax you pay later when you really want to sell the investment if you end up in a higher tax bracket. And many people do end up in higher tax brackets in the future due to things like pay raises, starting Social Security or pension benefits after retirement, or taking required minimum distributions at age 72.
So You Got a Letter from the IRS
Even if your taxable income is normally too high to harvest gains with zero tax, there may be some years where it may fall to a point where you can take advantage of this strategy, such as when you are:
- Temporarily unemployed.
- A self-employed person and your income varies from year to year.
- Between the ages of 60 and 72 and retired, before you start taking required minimum distributions.
Also, you can sometimes intentionally create a low-tax year that qualifies for gain harvesting by delaying a bonus until the next year, waiting to take taxable distributions out of retirement accounts until you’re required to do so at age 72 (or even later if you’re still working), and/or delaying your Social Security benefits until age 70.
An Example to Show How It Can Work
For example, let's say you're married, you just retired, and your taxable income for the year is going to be $50,000. Remember, the first $80,800 of your taxable income is taxed at a “0%” long-term capital gains tax rate — but for the sake of simplicity, and to build in a safety net so you don’t go over the limit, let’s round it down to $80,000. Therefore, you have $30,000 of long-term capital gains you can trigger without going over the $80,000 threshold and a “0%” capital gain tax rate will apply. In other words, you can capture this gain tax-free.
If you own stocks or mutual funds in a taxable account and some of your positions have unrealized long-term capital gains, you have a tax-planning opportunity here. You can sell enough of your investments to trigger $30,000 of long-term capital gain and pay no income tax on it.
And, assuming you want to keep these investments, you could simply buy them back immediately, and the $30,000 worth of taxable long-term capital gains will be eliminated forever, with no tax consequences, when you go to sell the investments later.
You do not have to wait 31 days to buy the investments back to abide by what is known as the “wash sale” rule, which only applies to taking capital losses, not capital gains.
Some Things to Watch Out for
Before you use this strategy be sure to check to see if you have any capital gains distributions that may pay out on mutual funds that you own in taxable accounts.
Mutual funds distribute capital gains each fall, although some funds distribute these funds as late as mid-December. These are gains that can be triggered even if you have not personally sold any of the mutual fund shares.
You’ll want to know what these gains are before you decide to intentionally realize additional gains. Otherwise, you could get thrown into a higher long-term capital gain tax bracket, which will be at least 15%, and end up paying tax on part of the gain.
Also, remember capital gains taxed in the 0% tax bracket are still income and will therefore increase your adjusted gross income, which could potentially increase your taxes in other areas. For example, it could result in reducing or disallowing the medical expense deduction if you itemize or trigger the taxation of otherwise non-taxable Social Security benefits.
So, while you have to do your homework to avoid some of these tax landmines, the fact remains that strategically harvesting gains in low-income tax years, may reduce your future tax liability and put more income in your pocket.
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