Five Simple Rules for Harvesting Capital Gains

Updated: September 1, 2015

The end of the year is upon us¹. Your tax advisor (if you have a tax advisor) may be asking you how much capital gain income you have. He or she may also be suggesting that you match any realized capital gains with capital losses to minimize your tax bill. Even if you don’t have a tax advisor, you may be asking yourself about your capital gains position, and what you should do about it.

Now, just raising the subject of capital gains and capital gains taxes may be enough to give you the willies. You may see it as just the first in an endless stream of complicated, confusing items you’ll have to deal with in the course of paying for the government that is a major element of the infrastructure of this great country of ours.

Fortunately, it need be neither complicated nor confusing. In fact, as Sensible Financial^TM‘s contribution to simplifying your year-end tax planning, we provide herewith our (soon to be) famous Five Simple Rules for Harvesting Capital Gains²:

1. Set your asset allocation first. Manage your taxes second.
2. Whenever possible, DO realize net capital losses of up to $3,000 in every calendar year³.
3. DON’T realize capital gains to offset capital losses realized in the course of diversifying or rebalancing your portfolio.
4. DO realize capital losses to offset capital gains realized in the course of diversifying or rebalancing your portfolio.
5. DON’T take capital gains just to realize them, even if you have offsetting unrealized losses.

If you’re willing to take our word for these rules, you can stop right here. If you’d like to dig a little deeper, keep on reading. We’ll apply our usual principles of simplicity and maximizing lifetime spending power.

The reasoning behind our Five Simple Rules focuses on just a few factors:

• Basis – the original investment cost of your portfolio
• Trading Costs – how much it costs to realize capital gains and losses
• Time Value of Money – a dollar today is worth more than a dollar tomorrow
• Tax Rates – capital gains tax rates are lower than ordinary income rates for many people (see footnote 3 above).
• Financial Life Phase – Most people have two main phases in their financial lives – the accumulation phase (saving and growing financial assets), and the distribution phase (spending the accumulated financial assets). In the accumulation phase, one typically doesn’t have capital gains and losses unless one is trading – and Sensible Financial recommends trading only to diversify or rebalance.

We’ll take the rules one at a time. The first ones apply mostly in the accumulation phase, when trades are focused on diversification or rebalancing.

1. Set your asset allocation first. Manage your taxes second. [The less comfortable you are with risk, the less a highly concentrated position is worth to you.] Diversification and asset allocation should be the primary drivers of your investment and trading decisions. If you save a few dollars in taxes one year by, say, deferring a capital gain in a concentrated position, and lose a lot in that concentrated position the next year, your overall spending power is reduced.
2. Whenever possible, DO realize net capital losses of up to $3,000 in every calendar year. [Reduce highly taxed income now, increase lower taxed income later.] Capital losses up to $3,000 reduce your earned income (taxed at higher rates) for tax purposes. Realizing the losses also reduces your basis in your investment portfolio, but any recovery of basis as the value of the investments grow will be taxed at (lower) capital gains rates. There are enough different index funds for most asset classes that you can replace funds sold at a loss with similar funds to maintain diversification. In fact, realizing more than $3,000 in losses can be a good idea – you can “carry forward” the losses into the following year, offsetting ordinary income then, too.
3. DON’T realize capital gains to offset capital losses realized in the course of diversifying or rebalancing your portfolio. [Defer paying capital gains taxes as long as you can.] This follows directly from the second rule – you want to preserve those capital losses to offset (higher taxed) ordinary income.
4. DO realize capital losses to offset capital gains realized in the course of diversifying or rebalancing your portfolio. [Defer paying capital gains taxes as long as you can.] This is again very like the second rule – if you’ve sold a concentrated position, or you’ve reduced a position that has made your portfolio too risky, and you have some unrealized capital losses you can take, why not take them? Again, you can buy a comparable index fund to replace most positions.
5. DON’T take capital gains just to realize them, even if you have offsetting unrealized losses. [Defer paying capital gains taxes as long as you can. Minimize trading costs,] There is no point in paying taxes just to pay them. One might argue that Congress is likely to increase the capital gains tax rate to its previous 20% level. Even this is not necessarily a reason to make the sale now⁴.

In the distribution phase of your financial life, you will find yourself faced with choices between selling assets in taxable accounts with significant unrealized capital gains and selling assets in tax deferred accounts such as IRAs and 401(k)s. While there can be estate planning issues that are too complex to address in this brief article, if your estate is not large enough to require the payment of estate taxes, spending power is maximized by using the assets in your taxable account first. [Pay lower capital gains taxes now, pay higher ordinary income taxes later.]

The bottom line:

• Get your asset allocation right first – get out of risky holdings even if you have gains – who knows how long the gains will last?
• Take your losses as they are available – they help reduce income taxes.
• Defer your capital gains – don’t pay taxes until you need the spending power.

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¹We first published this article in November, 2003. November and December are good months to read it in, but you can benefit anytime thinking about realizing significant capital gains or losses.

²With apologies to ABC.

³If your marginal income tax rate is greater than 15% – income greater than $27,950 as a single person, or $46,700 if married filing jointly.

⁴In fact, the decision turns on when you will ultimately need the spending power. If you need the spending power soon after the tax increase, take the gain before the tax increase. If you can wait a long time, and your holdings are well diversified, take the gain when you need the spending power.