The Changing Capital Gain Tax Structure
For the past several decades, there have only been two capital gains tax rates - an ultra-low rate (10%, then 5%, now 0%) for those the bottom ordinary income tax bracket(s), and a single top rate (20%, now 15%) for all other capital gains income. Thus, regardless of whether someone had $50,000, or $250,000, or $500,000 of capital gains, once past the bottom bracket(s) all capital gains were subject to the same flat top rate.
In 2013, though, this is no longer true. The introduction of a new top 20% capital gains tax bracket (on top of the existing 0% and 15% rates), along with the introduction of the new 3.8% Medicare surtax, effectively creates four long-term capital gains tax brackets: 0%, 15%, 18.8%, and 23.8%, with progressively higher rates as income rises. The significance of these new rules is not merely that capital gains may be subject to a new higher top tax rate; the presence of this new four tax bracket structure for capital gains rates dramatically changes the economic value and potential "risks" of tax deferral.
Push Capital Gains Into the Future?
The problem is that in the context of capital gains, systematically deferring gains and harvesting losses can create a larger and larger looming capital gain, and with today's four-bracket structure a larger future gain can actually result in less wealth. While in the past the tax rate might have been the same for a $50,000 and $500,000 capital gain (at least for those beyond eligibility for 0% rates), now it can be the difference between paying 15% tax rates and 23.8% instead. Pushing gains into the future that trigger the 3.8% Medicare surtax, and possibly the new top capital gains rate as well, can overwhelm the value of tax deferral itself.
Harvesting Capital Gains Now?
Accordingly, those who are eligible for favorable long-term capital gains tax rates should consider harvesting gains in order to "lock in" tax rates at today's rates, if they are favorable. The good news is that harvesting gains is much easier than harvesting losses. While claiming losses requires managing around the so-called "wash sale" rules that prevent the purchase of a substantially similar security within 30 days before/after the sale that produced a loss, there is no such rule for harvesting capital gains; Congress does not have a rule that states "you owe us taxes, but since you bought the investment again, you don't have to send us the money." To the contrary, selling an investment and buying it back must trigger income recognition and a potential tax event; except that with today's capital gains rates, that can actually be an effective tax arbitration strategy, even if it simply means selling investment positions that are up and buying them back immediately!
Similar to harvesting Roth conversions, though, the key again is not to harvest such large gains that the current tax bracket is bumped into the upper levels. Instead, the goal is to harvest just enough to fill the lower tax brackets, stop before reaching the upper brackets, and then wait to repeat the process again next year! In addition, it's also important to note that those who are harvesting capital gains should not harvest losses as well; just as harvesting gains creates wealth by capturing gains at lower rates, it's also advantageous to defer losses to the future when rates will be higher (assuming, of course, that the individual projects that their tax rates will be higher in the future than they are now in the first place).
For the past several decades, there have only been two capital gains tax rates - an ultra-low rate (10%, then 5%, now 0%) for those the bottom ordinary income tax bracket(s), and a single top rate (20%, now 15%) for all other capital gains income. Thus, regardless of whether someone had $50,000, or $250,000, or $500,000 of capital gains, once past the bottom bracket(s) all capital gains were subject to the same flat top rate.
In 2013, though, this is no longer true. The introduction of a new top 20% capital gains tax bracket (on top of the existing 0% and 15% rates), along with the introduction of the new 3.8% Medicare surtax, effectively creates four long-term capital gains tax brackets: 0%, 15%, 18.8%, and 23.8%, with progressively higher rates as income rises. The significance of these new rules is not merely that capital gains may be subject to a new higher top tax rate; the presence of this new four tax bracket structure for capital gains rates dramatically changes the economic value and potential "risks" of tax deferral.
Push Capital Gains Into the Future?
The problem is that in the context of capital gains, systematically deferring gains and harvesting losses can create a larger and larger looming capital gain, and with today's four-bracket structure a larger future gain can actually result in less wealth. While in the past the tax rate might have been the same for a $50,000 and $500,000 capital gain (at least for those beyond eligibility for 0% rates), now it can be the difference between paying 15% tax rates and 23.8% instead. Pushing gains into the future that trigger the 3.8% Medicare surtax, and possibly the new top capital gains rate as well, can overwhelm the value of tax deferral itself.
Harvesting Capital Gains Now?
Accordingly, those who are eligible for favorable long-term capital gains tax rates should consider harvesting gains in order to "lock in" tax rates at today's rates, if they are favorable. The good news is that harvesting gains is much easier than harvesting losses. While claiming losses requires managing around the so-called "wash sale" rules that prevent the purchase of a substantially similar security within 30 days before/after the sale that produced a loss, there is no such rule for harvesting capital gains; Congress does not have a rule that states "you owe us taxes, but since you bought the investment again, you don't have to send us the money." To the contrary, selling an investment and buying it back must trigger income recognition and a potential tax event; except that with today's capital gains rates, that can actually be an effective tax arbitration strategy, even if it simply means selling investment positions that are up and buying them back immediately!
Similar to harvesting Roth conversions, though, the key again is not to harvest such large gains that the current tax bracket is bumped into the upper levels. Instead, the goal is to harvest just enough to fill the lower tax brackets, stop before reaching the upper brackets, and then wait to repeat the process again next year! In addition, it's also important to note that those who are harvesting capital gains should not harvest losses as well; just as harvesting gains creates wealth by capturing gains at lower rates, it's also advantageous to defer losses to the future when rates will be higher (assuming, of course, that the individual projects that their tax rates will be higher in the future than they are now in the first place).
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