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When To Harvest Gains, When To Harvest Losses

It's harvest time again! The end of the year often presents golden opportunities for investors to "harvest" capital losses by selling stocks that can offset capital gains they realized earlier. But sometimes the reverse is called for—harvesting capital gains to make good use of earlier losses. Handling this the right way could have a major impact on your current tax liability.

Start with the basic premise that capital gains and losses from securities transactions are treated as short-term gains or losses if you've held the assets a year or less and long-term if you've owned them longer. Gains and losses are "netted"--losses are subtracted from gains--when you file your tax return. But you'll want to act months earlier, deciding to realize gains or losses, either short-term or long-term, depending on what works best in your particular situation.

If you still show a capital loss for the year after using your losses to offset your capital gains, one option is to use the excess loss to offset up to $3,000 of ordinary income, now taxed at rates as high as 39.6%. If that still doesn't use up all of your losses, you get to carry over the remainder to the following year and maybe the one after that and so on until the loss is exhausted.

The tax rules for capital gains are a little trickier. Short-term gains are taxed at ordinary income tax rates. But long-term gains are taxed at a maximum tax rate of 15% for most filers and 20% for investors in the top 39.6% bracket for ordinary income. Investors in the two lowest ordinary income tax brackets of 10% and 15% may benefit from a 0% tax rate on long-term capital gains.

To complicate matters further, a 3.8% surtax applies to the lesser of your "net investment income" (NII) or the amount by which modified adjusted gross income (MAGI) exceeds a threshold of $200,000 for single filers and $250,000 for joint filers. (If your income falls below those amounts, this surtax won't affect you.) The definition of NII includes capital gains from securities sales. As a result, if you realize a short-term gain this year, you could be stuck with a combined federal income tax rate of 43.4% (39.6% + 3.8%) if you're in the top tax bracket, not to mention any state income taxes you might have to pay.

Against this backdrop, these general principles could help guide your harvesting decisions:

To see how all of this may play out, consider the following examples of year-end tax planning. (For simplicity's sake, these don't involve the NII surtax or other complications.)

Example 1: You have a long-term loss of $10,000 and can realize a short-term capital gain of $8,000. If you harvest the gain, the entire amount is absorbed by your loss and you still can offset $2,000 of ordinary income.

Example 2: You have a long-term gain of $10,000 and can realize a long-term loss of $10,000. Although you might harvest the loss to offset the gain completely, consider the implications if the gain will be taxed at 15% or 20% or, even better, at the 0% rate. It may be better to preserve the loss for next year.

Example 3: You have a short-term gain of $5,000 and can realize a long-term loss of $8,000. If you harvest the loss, it will offset a gain that could be taxed at a rate as high as 39.6%, plus you can offset an additional $3,000 of ordinary income.

Example 4: You have a short-term loss of $7,000 and can realize a long-term gain of $10,000. If you harvest the gain, $7,000 will be absorbed by the loss. The remaining $3,000 of gain will be taxed at a rate no higher than 20%.

As these examples suggest, year-end harvest planning for taxes can hinge on many factors. We can help you consider all of the financial ramifications in light of your overall investment plan.