It could be time to harvest capital gains and future tax savings
Thursday, November 07, 2013
Did you buy Twitter stock today when the Internet company went public? Neither did I.
I am hoping, though, that the tech mutual fund I own did pick up some shares.
And I hope the Twitter folks are successful, not only because of my possible future earnings potential, but because the 140-character online connector is my favorite of the social media offerings -- despite this very long sentence and my overall tendency toward lengthy blog posts! (BTW, I'm @taxtweet.)
Today's stock market twittering attention got me thinking about an annual year-end tax-planning rite, the evaluation of portfolios.
In most cases, folks are looking at their stocks for shares that haven't done so well. By selling losers, popularly referred to as tax loss harvesting, you can offset any capital gains and perhaps up to $3,000 in ordinary income on which you'll owe taxes.
But you might also want to consider tax gain harvesting.
Cashing in investment winners: As its name suggests, you harvest capital gains when you sell stocks that have appreciated nicely. When they are assets you've owned for at least 366 days, i.e., more than a year, they then are long-term capital gains and generally are taxed at more favorable rates.
Taxpayers in the 10 percent and 15 percent tax brackets owe no capital gains taxes on such sales. Most taxpayers will owe 15 percent tax on long-term capital gains. Wealthier taxpayers will owe a 20 percent tax on long-term gains plus, depending on just how rich they are, additional taxes on their investment income.
Table courtesy Tax Foundation. Click image for a look at historical capital gains tax rates.
So you ask, if I don't have an immediate need for the money, why in heaven's name would I want to sell and pay taxes, even at rates lower than ordinary tax rates, on the profit? Isn't the conventional tax wisdom to delay tax payments for as long as possible?
Good questions. Here for some folks is a good answer. You want to reset your cost basis.
Basis determines profit, tax due: The value of any asset is what is known in the tax and investing worlds as its cost basis, or simply basis.
Basis begins with the price you paid for the asset. Certain actions and transactions can increase an asset's basis. When you eventually sell that asset, its basis is used to calculate the profit you make. And it's the profit on which you pay tax.
To find your taxable profit, you subtract the asset's basis from its sales price. The larger your profit, the larger your potential tax bill.
So you want to reduce your profit, at least when it comes to tax computations, in order to lower your tax bill.
A larger basis amount will do that.
And tax harvesting can help you reset your basis so that as the stock's value continues to appreciate, you'll have a larger basis to use in calculating your profit.
Sell then rebuy: In tax gain harvesting, you sell the stock and then use the money to repurchase shares of the asset. By doing so, you still have the same amount invested as you did originally in the stock, but now the share price, your basis, is at a higher level.
That increased value will be used when you sell the stock again more than a year later to determine your capital gains tax then.
This simple, for-illustration-purposes-only example explains:
You bought 100 shares or XYX Corp. five two years ago at $50 a share, giving you a basis of $5,000.
You sell the shares at today's price of $75 apiece, or $7,500. That gives you a profit of $2,500 on which you owe no capital gains tax because you're in the 15 percent ordinary income tax bracket.
You use your $7,500 to rebuy 100 shares of XYX Corp. at $75 a share. This resets your basis in the stock at $7,500.
In five years, you sell your 100 XYX shares that are now worth $125 apiece. That gives you $12,500.
Using your reset basis, you owe capital gains on $5,000 ($12,500 minus $7,500). You now are in the 25 percent tax bracket, meaning your capital gains tax rate is 15 percent, producing a tax bill on your profit of $750.
If, however, you had simply held the original $50 apiece XYX shares, your taxable profit on your final sale would have been $2,500 more or $7,500 ($12,500 minus $5,000). And your 15 percent capital gains tax bill would have been $1,125.
Of course, with stocks things could go the other way, meaning you'll have a larger loss to harvest. As noted, that could be good if you need tax losses at filing time.
But for today's purposes, we're going to be upbeat and go on the assumption that you picked a sure-fire investment winner. (If that is indeed true, let's talk!)
No wash worries: If you're worrying about the wash sales rule (1) thanks for paying attention to my earlier posts on this topic and (2) don't.
The wash sale rule, which says you cannot take tax advantage of a losing asset and then repurchase substantially the same stock, only applies to losses. Basically, the Internal Revenue Service doesn't allow you to sell a dog of stock solely to get a tax break.
However, when you sell a stock that's gained in value and on which you pay tax, then the IRS is fine with you rebuying not only a substantially similar stock, but the actual stock itself. The tax man is getting his cut on your sale profit, so what you subsequently do with your portfolio is fine with him.
Heck, Uncle Sam is glad you're buying back a winning stock since he's likely to get more of your money from it later!
Who should harvest tax gains? For someone whose income tops out at the 15 percent tax bracket, tax gain harvesting is a no-brainer.
You'll owe no capital gains tax now and by resetting your asset's basis, it could help reduce your possible capital gains tax when you sell the repurchased shares later and are in a higher tax bracket.
Just make sure that the income from the asset sale doesn't push you into the 25 percent tax bracket.
Folks who will face some capital gains tax on the sale, however, need to do some calculating, investment prognosticating and soul searching.
Do you have the money, beyond the sales assets, to pay the taxes? Do you believe the holding will continue to grow in value? Are you comfortable making the move?
Tax gain harvesting might not be the best choice for you, either financially or emotionally. But at least look into it and discuss it with your tax and financial adviser(s).
And to today's buyers in the Twitter IPO, good luck!
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