It is time to harvest! No, not agricultural harvesting, that is almost done. I am talking about capital gains harvesting. What is gains harvesting you ask? Well, I am glad you asked.
Normally when you invest money in the stock market through a brokerage company such as Vanguard, Sharebuilder, E*Trade, Fidelity, etc. you will end up paying taxes on any extra money you get out. How much you pay depends on a number of factors including how long you held onto the security (stock, mutual fund, index fund, bond, etc), how much of a gain you had, and your ordinary tax rate.
Generally you will want to hold onto securities for at least one year. By doing so they will be classified as “long term” capital gains and be taxed at 15%. Any profit you make by selling a stock before the first year of ownership is a “short” term capital gain and is taxed at your ordinary tax rate. For most married single income families that will also be 15%, but it may be higher as the next tax bracket starts at around $72k of income and jumps to 25% tax rate.
Making a profit on a stock sale will count towards your taxable income. For example, if you owned XYZ for 9 months and made $5k by selling it and your day job brings in $68k after exemptions and deductions then you would fall into the 25% tax bracket.
A common misconception with taxes is that moving up in tax brackets because of an increased income will result in less take home money. That is completely false. If your boss offers you a raise, TAKE THE RAISE! Even if it puts you into a higher tax bracket. The United States uses a marginal tax rate system, meaning if you move into a higher tax bracket, only the money in the higher bracket is taxed at the higher rate. Investopedia explains the system well.
Getting back to the topic on hand, there exists a ‘loop hole’ of sorts that lets you sell long term capital gains and pay NO tax on it! There are of course some rules.
- It must be a long term capital gain (owned for over a year and in the positive)
- You must be in or below the 15% tax bracket with the gain included in that
This is the first year that we are taking advantage of gains harvesting. We’ve been in the stock market for about eight years now and we have a buy and hold mentality, so the field is ripe for harvesting.
The first step is to do some back of the envelope calculations and figure out how much wiggle room we have in the 15% tax bracket. With the end of the year close by, you should have a pretty good idea of what your 2014 numbers will be. We used Turbo Tax’s free Taxcaster website to come up with some rough calculations.
Once you know your taxable income, you can figure out your current tax bracket. If you are above 15% you may be able to squeeze down by contributing to a 401k, IRA, HSA, or other tax advantaged account. If you are in or below the 15% tax bracket you can figure out how much capital gains you can reap while staying in the 15% bracket.
Knowing the above information, we sold and then immediately repurchased shares of stocks that had long term capital gains. We spent:
$7 to sell stock (brokerage commission fee)
$7 to buy stock (brokerage commission fee)
and there was a price difference from when we sold to when we bought (within a minute) that ended up costing us $15.
So for about $29 we harvested long term capital gains and saved around $1500 in taxes.
Besides saving taxes, this strategy also pays off down the road. Two examples would be.
1.) Next year the stock market tanks. Our cost basis, what we paid for the stock, would be more than what the stock is worth and it would be a loss. We could sell that loss and count it against our income, lowering our tax bill. This is called loss harvesting and has some extra rules that apply to it.
2.) Next year the stock market goes up and we want to sell and lock in our gains. Instead of a giant gain that could easily bump us up into a higher tax bracket, it would be smaller because we have already harvested some of those gains.
For another explanation of Gains Harvesting, check out this blog.
If you haven’t started investing in the stock market yet and don’t know where to start, then Betterment.com might be a good place to get going. They offer plenty of hand holding (I haven’t personally used them and don’t benefit from promoting them).
If you want more control over your investments and haven’t started yet, then Vanguard.com is a safe bet. Betterment just uses Vanguard funds and charges a little extra on top to cover their middle man status.