Does Tax Gain Harvesting Make Sense for 2012?

Does Tax Gain Harvesting Make Sense for 2012?

You may be familiar with the term “tax loss harvesting.” Towards the end of each year, many investors routinely sell assets such as stocks or mutual funds with embedded losses in order to offset the current taxes they will have to pay on gains from other assets. This strategy generally works well during periods of steady or declining tax rates. However, if you really wanted to keep those stocks or funds and only sold them for the purpose of taking tax losses, you’d need to buy them back right after selling them. The IRS doesn’t appreciate investors executing this maneuver for the sole purpose of deferring taxes. So they require you to wait 31 days or more before repurchasing the asset (or a substantially identical asset), otherwise they will add the loss back on to your cost basis and treat the sale as if it never happened. This is known as the wash sale rule, and complying with it can make this strategy a bit tricky to execute.

This year we are facing multiple tax increases for 2013. The 15% long-term capital gains tax rate has the potential to go up to 20% if Congress fails to restore some or all of the EGTRRA tax cuts set to expire on December 31. In addition, married taxpayers with incomes over $250K will see their capital gains tax rate go up by an additional 3.8% in order to fund the Affordable Health Care Act (this one is a sure thing). Under these circumstances, tax loss harvesting probably doesn’t make sense. But you can do the reverse (tax gain harvesting), and it’s completely acceptable to the IRS.

The strategy involves selling assets with embedded long-term gains before the end of 2012, then immediately buying them back. All the gains accumulated since the assets were originally purchased will be taxed this year at the current 15% rate, and only any future gains will be taxed at the higher 2013 rates. Not only is this strategy simple to execute, it does not run afoul of the wash sale rule, since that only applies to losses, not gains. (The IRS is perfectly happy when you make your tax payments sooner rather than later).

It’s important to remember that this strategy only applies to investments held in taxable accounts, not in retirement accounts like IRAs or 401(k)s. Since the money you put into latter accounts was never taxed (except under certain circumstances), the IRS doesn’t care how much you paid for your investments. You will be taxed at ordinary tax rates when the money is withdrawn.

If you are a high-income taxpayer, tax gain harvesting in 2012 will save you at least 3.8% in taxes on your investments. For everyone else, you need to balance your expectations of higher tax rates – what are the odds that our lawmakers will reach a deal before the end of the year – with your own cash flow needs for this year and next. Don’t wait too long before having this conversation with your tax accountant or financial planner.

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