Tax Gain Harvesting Explained

Tax gain harvesting is the inverse of a more commonly used strategy called tax-loss harvesting, acting as an offensive play involving selling appreciated assets in a lower-income year in order to lock in profits at a lower tax rate before repurchasing them to reset your cost basis.

It is essentially a way to pay your taxes early, usually for free or at a massive discount, in order to protect your future returns.

How Tax Gain Harvesting Works

In simple terms, this strategy is based all around the relationship between the initial purchase price (cost basis) of a security you bought, and its current market value. The gap between the prices is what represents your taxable gain.

When you sell your security that is appreciated in value and then immediately purchase it back, you establish a new cost basis from that price point.

Tax gain harvesting is not as heavily restricted as tax-loss harvesting, which requires a 30-day wait period to claim a loss due to the IRS Wash-Sale Rule. 

With tax gain harvesting, you are free to realize your gain and report it on your 1040, allowing you to maintain market exposure while wiping away the tax liability on all previous growth.

When you eventually sell the asset for good years down the line, your taxable profit will be calculated from this new, higher starting point.

When Tax Gain Harvesting Is a Good Idea

The most commonly used approach that investors use is to lean into tax gain harvesting during a year when their income is lower than usual. 

With the current federal tax code, you will pay a flat 0% long-term capital gains tax rate if your taxable income, including the gains you harvest, stays below $49.450 (or $98,900 for married couples filing jointly).

The second scenario that can use this strategy effectively is if you retired early and have not yet reached the age of Required Minimum Distributions or Social Security. 

During this period of time, you can use tax gain harvesting for permanent tax avoidance, as you have complete control over your reported income.

It’s also quite a powerful tool for portfolio rebalancing, especially when one section of your investment portfolio outperforms others and exposes you to concentration risk.

If this happens during a low-income year, you can capture the overperformance of a sector and then move that capital to other sectors to increase diversification without the IRS taking a cut of your growth.

Finally, you can use tax gain harvesting if you expect future tax legislation to increase capital gains rates. 

Tax policy is rarely static, and tax brackets can shift or introduce surtaxes to address federal deficits, so if you are sure that the rates will increase, you can harvest your gains right now and lock in a rate, basically as an insurance against future legislative hikes.

This is particularly vital for high-growth assets that are currently within your control to tax at a discount.

Potential Risks to Consider

While tax gain harvesting can obviously be used to your advantage, the truth is that it is not an advisable choice to make for many investors, as there are a number of things that factor into this strategy aside from looking at the 0% capital gains bracket.

• The Loss of Compounding Power: If you are not in that 0% bracket and choose to harvest gains at the 15% or 20% rate, you are voluntarily surrendering capital to the IRS today that could have otherwise stayed invested and compounded for decades.
• The IRMAA Trap: For retirees, the IRS shares your AGI with the Social Security Administration. If your harvested gains push your income above the current thresholds ($109,000 for singles or $218,000 for couples), you will be hit with an "Income-Related Monthly Adjustment Amount" (IRMAA). This is essentially a surcharge on your Medicare Part B and D premiums that triggers two years after the harvest.
• State Tax Exposure: Federal tax law may offer a 0% rate, but many states (like California or New Jersey) do not. You might successfully avoid federal tax only to trigger a 5% to 9% state tax bill.
• The Credit Phase-Out: A higher Adjusted Gross Income (AGI) can accidentally disqualify you from valuable tax breaks, such as the Child Tax Credit, the Senior Deduction, or the ability to deduct student loan interest.
• Charitable Opportunity Cost: If you plan on donating to charity in the future, harvesting gains is often a mistake. Donating highly appreciated securities directly to a charity or a Donor-Advised Fund (DAF) allows you to bypass the capital gains tax entirely while receiving a full deduction.

Final Words

As you can see, tax gain harvesting can be used effectively in multiple scenarios to replace the fear of selling with the discipline of tax-bracket management. By resetting your cost basis during lower-income years, you can achieve greater control of your future new worth.

Still, you have to be aware that your harvested gains increase your Adjusted Gross Income, and that there are times when this approach can be disadvantageous to you.