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Reap Tax Rewards from Year-End Harvesting

The stock market has experienced plenty of ups and downs this year. So some investors are poised to take big gains for 2019, while others are currently showing losses and many have both.

What are the tax consequences if you sell securities? There's no fast answer. But it helps if investors understand the basic rules and plan accordingly at year-end. Here's a brief overview.

Create Net Results

Notably, capital gains and losses from securities transactions are treated as short-term gains or losses if you've held the securities for a year or less and long-term if you've owned them for more than a year. Gains and losses are "netted" to produce the final results. Thus, you may be inclined to "harvest" (or realize) gains or losses as we head toward the end of the year, depending on your situation.

  • If you're showing a net gain, you can harvest a loss to offset the gain. In effect, the gain is tax-free. Any excess loss can offset up to $3,000 of highly-taxed ordinary income like wages from your job. Any remainder can be carried over indefinitely.

  • If you're showing a net loss, you can harvest a gain to offset the loss. In effect, the gain is tax-free up to the amount of the loss. Any excess is taxable under the usual capital gain rules.

As you'll see below, the differences in tax rates for short-term capital gains and long-term gains may dictate your planning strategies for the rest of the year.

Max Out Capital Gains Benefits

For starters, short-term gains are taxed at the same rates as ordinary income. Therefore, an investor in the top tax bracket of 37% in 2019 must pay $370 in capital gains tax on a $1,000 gain, absent any offsetting losses.

But long-term gains benefit from favorable tax treatment. The tax rate on a net long-term capital gain is 15% for many taxpayers even if you're in a higher regular income tax bracket. The maximum rate increases to 20% for certain high-income investors. Under the Tax Cuts and Jobs Act (TCJA), the thresholds for the 20% rate are tied into special tax brackets for this purpose and are indexed for inflation. (Previously, the 20% rate applied to investors in the top two ordinary income tax brackets.)

Taking these rules into account, it generally makes sense to offset a loss with a short-term gain that otherwise would be taxed at high ordinary income rates. Conversely, if you have a short-term gain, you may want to offset it with a long-term loss, rather than using a valuable short-term loss, to offset a long-term gain.

Key point: In some situations, investors qualify for a 0% tax rate on long-term gains. As with the 20% capital gains rate for high-income investors, the thresholds for the 0% rate are set by the TCJA.

Typically, the 0% rate applies to low-income taxpayers like your young children. But a portion of your income may be taxed at the 0% rate even if you're a middle-to-high income taxpayer overall. This often occurs when retirees harvest capital gains and don't have much other income during the year.

Other Special Considerations

Other special rules may have an impact on year-end tax planning. Here are three to consider.

1. Net investment income tax (NIIT). A 3.8% tax 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. The definition of NII includes capital gains from securities transactions.

For instance, if you harvest a short-term gain in 2019, you might be stuck with a combined federal income tax rate of 40.8% (37% + 3.8%) if you're in the top tax bracket, not to mention state income taxes.

2. Wash sale rule. Under this rule, you can't claim a loss on the sale of securities if you acquire "substantially identical" securities within 30 days of the sale. There's no bright-line test for this determination, so err on the side of caution.

To avoid the wash sale rule, you might wait at least 31 days before you reacquire comparable securities.

3. Municipal bonds. Be mindful that investments in municipal bonds ("munis") and muni bond funds are exempt from federal income tax and state income tax if you reside in the state of the issuing authority. But sales involving private activity bonds may cause alternative minimum tax (AMT) complications. Consult with your tax advisor.

Now that you've grasped the lay of the land, develop a plan for harvesting gains and losses that meets your needs. Consider all the financial aspects — not just taxes.