Tax Gain Harvesting – Penny Pinching for the Early Retiree?

Taxes are a penalty for doing well. I’d rather receive a hefty penalty than no penalty at all.

– Redacted


When I first heard about Tax Gain Harvesting, I was super excited to have come across another strategy to increase my investment returns. The strategy works best if you have an income small enough that it does not trigger long-term capital gains tax, so I stowed it away in my mind for when I early-retired.

When I finally early-early retired, my mind started bugging me to execute this advanced strategy and write a post about my experience.

But…

After looking into the details, I decided I didn’t want to, even though my income this years makes the strategy feasible.

I’ll get to why that is. First, let’s understand what is Tax Gain Harvesting.

What is Tax Gain Harvesting?

It’s the reverse of Tax Loss Harvesting.

The idea behind Tax Gain Harvesting is to increase the the cost basis for your asset to reduce future taxes when you realize the gain.

In English, it’s something you can do to be able to tell the IRS that you made less profit so they don’t tax you as much.

Example?

Example

Investment asset: car
Your yearly income: $40,000

Two scenarios: One without Tax Gain Harvesting to serve as a baseline for the second, which will include Tax Gain Harvesting.

Scenario 1: No Tax Gain Harvesting

In 2015, you buy a car for $1,000. This is your cost basis for the car.

In 2019, someone offers to buy your car for $16,000. Amazing.

You sell. Your realized gain is $15,000.

Because you have owned the car for more than a year, the IRS considers this a long-term capital gain (LTCG) and taxes you according to your income for the year:

Long Term Capital Gains rate for single filers in 2019

Taking your earned income and adding in the capital gain — which our taxation agency also consider income — your income is $55,000, putting you into the 15% LTCG tax rate. You owe $2,250 on your LTGC from selling the car. (15% of 15,000).

You get to keep $12,750 of the gain from your car sale.

Note 1: We are not including income tax on the $40,000 you made this year. Yet.

Note 2: If you live in a stealy state, like California, you will have to pay additional state tax. California taxes capital gains as regular income. So in this case, you’d have to pay the Franchise Tax Board tax based on whatever bracket $55,000 income put you in.

Scenario 2: With Tax Gain Harvesting

In 2015. You buy a car for $1,000. This is your cost basis for the car.

Each year, you check in on the value of your car. You find that because the company stopped making them, and people are crashing them left and right, the value is going up.

In 2017, you find that you can get $4,000 for your car. Because the value of the car is likely to continue rising, you decide to Tax Gain Harvest.

You go on unpaid leave for two months because you want your to be low enough that you can be in the 0% LTCG tax rate. Going on leave for two months allows you to reduce your income for the year to $33,333.

You sell your car, then buy it back immediately for $4,000. This is your new cost basis for the car.

Your earned income of $33,333 plus the first realized gain of $3,000 from the car puts your income at $36,333, low enough to qualify for the 0% LTGC rate. Therefore, you do not pay tax on your $3,000 gain.

In 2019, someone offers to buy your car for $16,000. Amazing.

You sell. Your second realized gain is $12,000 because you reset your cost basis to $4,000 in 2017.

Because you have owned the car for more than a year, the IRS considers this a long-term capital gain (LTCG) and taxes you according to your income for the year.

Deja vu?

In 2019 you’re back to making $40,000, so your total income ($40,000 + $12,000) puts you into the 15% LTCG tax rate. You owe $1,800 on the $12,000 gain you made on the car sale.

After all is said and done, you get to keep $13,200 of your gain from the car transactions.

Note: You could also have gone on unpaid leave for four months in 2019 when you sold the car a second time to get into the 0% LTCG tax rate to keep the full $15,000 gain.

Example analysis

You are probably getting the idea that Tax Gain Harvesting is not really worth the effort, because the additional amount you get to keep from the car sale is pretty small. You’d get to keep $12,750 without TGH, and $13,200 with TGH.

Only $450 more.

If you had lowered your income in 2019 to meet the 0% LTCG tax income requirement and kept $15,000, you would have been able to keep $2,250 more.

In my opinion, the amount is too small to justify all the extra stuff you have to do to sell and buy your car, like transfer fees, getting a smog check, visiting your local DMV, and the time you gotta spend on making sure all the paperwork is done properly. With all that factored in, it could easily eat up your margin. Plus, If you accidentally get a raise at work, you’d be screwed!

Plus, you must earn a lower income in the year that you do the harvesting or else there is nothing to gain. But the very fact that you must lower your income makes the whole exercise moot. In scenario 2, you made around $7,000 less one year so that you could save $450 on taxes. If you skipped work when you sold in 2019, you’d be out even more.

I know the numbers are getting hard to keep track of, so here’s a table showing each scenario. I added scenario 2b where we took a four month leave in 2019 as well.

A loophole to consider overlooking.

Personal Example

Since I had no income last year, I thought about doing Tax Gain Harvesting. Ever since I first read about it on Mad Fientist’s site, I’ve been eager.

Well, I decided not to.

Here’s why:

I was setting my sights on harvesting $35,000 worth of investment gains so I would be well within the qualification income for the 0% Long-Term Capital Gains tax.

I have VTSAX in my portfolio, so let’s pretend, for simplicity’s sake, that I had a bunch of VTSAX purchased mid 2016 at $54.48/share.

On December 17, 2019, VTSAX was priced at $79.14/share.

On December 17, I would be able to harvest 1,419 shares to stay within my harvest goal.

Math: $35,000 / ($79.14 – $54.48) ≈ 1,419 shares

To harvest, I would sell 1,419 shares, then immediately buy back 1,419 shares at VTSAX’s current price.

My income from doing this is just under $34,993.

  1. I pay zero federal income tax on the transaction.
  2. I pay $712 in CA state income taxes. Stealy state, remember?

My tax basis for those 1,419 would be reset.

  • I previously owned 1,419 shares at $54.48/share
  • Now I own 1,419 shares at $79.14/share.

At this point, I just wait for the investment to grow. Let’s say 40 years, and that the investment grows 9% CAGR.

After 40 years, I would have 1,419 shares at $2,485/share.

  • Because I tax gain-harvested, my gain would be $2,405/share.
  • If I had not tax gain harvested, my gain would be $2,430/share.

So basically, tax gain harvesting would save me just around $35,475 over 40 years.

Math: 1,419 shares ∙ ($2,430 – $2,405) ≈ $35,475

Sounds pretty good, right?

But, remember how California stole taxed me $712 when I tax gain harvested?

Investing $712 at 9% CAGR for 40 years is $22,363.

In California, Tax Loss Harvesting only saves $13,112.

Add in the extra cost for the more advanced version of tax prep software to deal with the forms for buying and selling stock, it’s worth even less.

Add in the time you spent preparing everything, making sure the strategy was executed exactly, and the worry about if you get a year-end bonus…. You get the point.

But here’s the real kicker. Provided that my 1,419 shares would be worth $3.5 million, my little tax gain harvesting exercise provides, at most, 1% additional growth at the end of 40 years (0.3% if you live in a stealy state).

1%.

Would I be better off clipping 15%-off grocery coupons today?

By the way, I’m also not counting the eventual LTCG tax I’d pay when selling the shares in 40 years. Including that would make the numbers even worse!

So why would anyone want to do Tax Gain Harvesting?

What I’ve outlined in the examples should appear absolutely absurd. Sure, theer is money to be “made” here, but there is a point you will get to in personal finance where enough is enough, and you have more important things to do than worry about getting an extra 1% on your portfolio over your lifetime.

You’ve heard the saying: 20% of the work gets you 80% of the way there.

In this case, if 20% of the work is developing good money habits, saving and investing consistently, it gets you >99% of the way there.

Like I said, I first read about Tax Gain Harvesting on Mad Fientist’s site. In his article, he explains the real reason someone would want to do Tax Gain Harvesting: To set the stage for Tax Loss Harvesting.

The IRS allows you to reduce your annual income by the amount of capital losses you have year, up to a cap (currently $3,000). If you lose more than the cap, you can carry over the extra amount to next year’s return.

This is much more valuable because you’re reducing the part of your income that is in the highest tax bracket. If you’re in the 37% federal tax bracket, you save $1,110 each year you max out your $3,000 allowable loss.

Pretty powerful.

Still, for this to make much sense, two things need to align:

  1. Your income would have to be low enough that you’re in the 0% LTCG each time you harvest gains. Otherwise, you’re eating away at the margin you’ll maybe get from your harvested losses.
  2. The shares you have must decrease in value in order to be able to harvest losses.

If you’re regularly saving and investing anyway, you could probably find shares you already own to sell should the market tank. Tax Gain harvesting in preparation for the eventual loss harvesting opportuinty is essentially another way of timing the market.

Conclusion

When it comes to personal finance, being “normal” may put you be better than looking for advanced strategies or IRS loopholes to exploit.

20% of the work gets you at least 80% – often more – of the way there. Writing about advanced strategies may be a cool thing to write about, but the theory may not translate well to real life.

If you come across an advanced sounding strategy that sounds really cool and shiny, make sure to read the comments.

Poor Blake

At this point, I feel that I should say, ask your financial professional if Tax Gain Harvesting is right for you.


I hope you enjoyed this article. If you have any questions, or comments, please leave a comment, or contact me directly.

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