A common tax planning strategy is to sell off stock or investments to create $3,000 in losses before year end so they can be deducted on your tax return against your regular incomme. The opposite strategy of “harvesting gains” may be a new strategy for 2012.

Since the Bush tax cuts are set to expire at the end of 2012, many are worried about the uncertainty of taxation of capital gains in the future. Currently the maximum federal income tax rate is 15% for long-term (more than one year) capital gains. Without further legislation, the 2013 rate of tax will be 20%.  This creates a risk for anyone with unrealized gains in their portfolio.

Just like Roth IRA conversions allowed you to pay the one time tax and “take the hit,” individuals with capital gains in their portfolio should do tax planning to determine how harvesting gains for 2012 will effect them.

For those who are not optimistic that a favorable capital gains rate will in place in the near future, this is how the harvesting gains strategy would work:

  1. Sell the stock or funds in 2012 and generate realized gains.
    • If you are selling stock, it is assumed to be sold as first in, first out (the oldest stock you own is considered to be sold first). You can however specify the lots being sold if you don’t want to sell the oldest ones first. You should document this and provide the information to your broker before selling.
    • Mutual funds are considered to have an average cost over time so verify your basis when determining your gain from selling.  You can however use the actual cost method and specify lots to sell but this should be documented and provided to your broker before selling.
  2. You can re-invest in these same companies and buy the stock or funds immediately.  Wash sale rules do not apply to gains so you do not have to wait 31 days as you would to be able to deduct losses.  You may also want to take this opportunity to review your portfolio and make sure your investments are allocated according to your current risk level.
  3. When you file your 2012 taxes, you will pay gains at the maximum rate of 15%.  Consider your state tax rates too since they will also apply.

How much could this save you?   No one knows what the future rates will be, but let’s take a look at an example with the current legislation as our assumption:

Mary has 1,000 shares of IBM stock and has a basis of $20 per share.  If she sells the shares at the current rate of $200 per share, she will have long term capital gains of  $180,000.  For 2012, her federal tax liability for capital gains would be $27,000.  If she waits until January 2013 to sell those same shares, her federal tax liability will be $36,000.  Those few months of waiting to sell just cost her $9,000 or 5% more.

We are ready to assist you with planning to determine if this is a sensible strategy for you.  Take advantage of our Tax Planning & Coaching services to learn how proactive tax planning can be your best investment yet.