[Update after publication April 2018: While long-term capital gains are taxed at 0% for investors in the 10% and 15% tax bracket, many investors will still have to pay state income taxes on all capital gains. This significantly reduces any benefit of tax gain harvesting for investors who otherwise did not plan to sell their stock for many years. In my opinion, very few investors with long-term time horizons and a state income tax on capital gains would benefit from tax-gain harvesting. -WSP]
The standard advice for most investors, including nearly all attendings, is to take advantage of tax-loss harvesting opportunities. You harvest losses and take deductions at a high tax bracket, while any future gains are taxed at a lower long-term capital gains bracket. This is a key investment principle that should be in the toolbox of all physician investors. But could there be some scenarios where physicians should consider tax gain harvesting? Let me explain and give you a concrete example of this concept.
A Special Scenario for Some Medical Residents
Long-term capital gains tax rates are 0% for people in the 10% or 15% tax bracket. This will typically apply only to married medical residents with a non-working spouse. Because residents will (one day) become attendings and be at a much higher tax bracket, it makes sense to cash in on long-term capital gains when you are a resident (and are eligible for a 0% long-term capital gains rate), rather than wait until you are an attending to cash in your investment gains as a resident, and be taxed at 15% (or if you’re lucky / good enough to be in the 39.6% top tax bracket, 20%).
Tips for Tax Gain Harvesting
1. Make sure tax gain harvesting is beneficial
The most important thing is to make sure that tax gain harvesting is actually beneficial to you.
Most single residents will not benefit from tax gain harvesting, since your income is typically greater than approximately $48,300 (the 15% tax bracket ends at $37,950 for single taxpayers, plus the $6,350 standard deduction and $4,050 personal exemption).
Most married residents with a non-working spouse will qualify, since your income is typically less than approximately $96,700 (15% tax bracket ends at $75,900 if married filing jointly, plus the $12,700 standard deduction and $8,100 personal exemption).
Some married residents with working spouses will qualify if they make a combined income of less than approximately $100,000. Your taxable income is on line 43 of Form 1040, Line 27 of Form 1040A, or line 6 of Form 1040EZ. If this number is less than $75,900, then you may benefit from tax loss harvesting.
1a. Reconsider tax gain harvesting if you have a long investment horizon and live in a state with state income tax
While long-term capital gains are taxed at 0% for investors in the 10% and 15% tax brackets, they are often NOT exempt from state income taxes. That means you may have to pay a tax bill for stocks you sell for tax gain harvesting purposes. Losing the compound interest capabilities of that state income tax bill may exceed the benefits of paying less in federal long-term capital gains tax. If you were planning to hold the appreciated stock for many years, then I would not do tax gain harvesting if your state has a capital gains tax.
2. Tax gain harvest in the last year before your year of graduation
For married residents with a non-working spouse, you have a lot of room for tax gain harvesting. In this scenario, you should perform all of your tax gain harvesting in the final year before graduation. For example, if you are graduating in June 2018, you should harvest all of your gains in 2017, since this will be the last year you will be making a resident salary and can benefit from tax gain harvesting.
This is beneficial because if you just tax gain harvest every year during residency, you may lose opportunities to get valuable tax credits (see Saver’s credit below).
3. Make sure your total income stays under the limit for the Saver’s Credit in non-graduation years
In 2017, the income above which the Saver’s Credit is phased out is $62,000 for a married filing jointly couple. If you are harvesting gains, please be cognizant that you will lose a nice tax credit (worth $400 if both you and your spouse contribute at least $2,000 to a retirement account) if your capital gains causes your income to exceed the income limit for the Saver’s Credit.
4. Consider tax loss harvesting in years that you do not tax gain harvest
In years that you do not tax-gain harvest, you should consider the standard advice of tax loss harvesting. For example, if you are graduating in 2019, and you have $4,000 in losses and $10,000 in long-term capital gains, one approach would be to take the $4,000 in losses in 2017 and the $10,000 in long-term capital gains in 2018. You will be able to deduct $4,000 on your 2017 taxes (netting you a $600 gain).
As you’ll see in the example below, the optimal scenario would be to harvest the losses in your first full-year as an attending, so that you can deduct your losses at the highest marginal tax rate. The problem is that those $4,000 in losses may reverse itself and become capital gains by the time you become an attending (a very good problem to have!).
5. Make sure your income does not exceed the 15% tax bracket
Remember that you can only tax gain harvest money up to the upper threshold of the 15% tax bracket (in 2017, $37,950 for single residents and $75,900 for married residents). Remember that your tax rate is based on your taxable income, which is calculated after the standard deduction, personal exemption, or itemized deductions are taken from your adjusted gross income.
6. Make sure you are only using long-term capital gains
Remember that only long-term capital gains receive the discounted tax rate for low-income investors. If you generate short-term capital gains (buy and sell the stock within 1 year), this will be taxed as ordinary income regardless of your tax bracket. Tax gain harvesting is for long-term capital gains only.
Putting it all together: an example
Consider a married resident / stay-at-home spouse couple with two kids who will earn $50,000 as a resident in 2017. The resident will graduate in June 2019. They have $4,000 in unrealized losses and $15,000 in unrealized long-term capital gains. Importantly, they live in a state with no state income tax. Here are five possible scenarios:
1. Tax loss harvest in 2017, tax gain harvest in 2018
The resident would take the $4,000 in losses in 2017, earning a 15% tax deduction on the losses, or $600. The resident would then take the $15,000 in gains in 2018, but would not have to pay any taxes, because he remains in the 15% tax bracket. The total taxes is a $600 gain.
2. Sell all stocks (both losses and gains) in 2018
The resident would take both the $4,000 in losses and $15,000 in gains in 2018. This would net out as $11,000 in capital gains for 2018, which the resident would not have to pay any taxes. The total taxes is $0.
3. Tax Loss harvest in 2019, tax gain harvest in 2020.
The resident (now attending) would take the $4,000 in losses in 2019. Now that he is an attending and paying attending-level taxes, he would be able to take a larger 33% tax deduction on the losses, or $1,333. The attending would then take the $15,000 in gains in 2020, but would have to pay a long-term capital gains of 15%, or $1,650. This leads to a net loss of $317.
4. Sell all stocks in 2019 or beyond
This is the worst scenario. The resident (now attending) would take both the $4,000 in losses and $15,000 in gains in the same year as an attending. This would net out as $11,000 in capital gains, for which the now-attending would have to pay a long-term capital gains of 15%, or a $1,650 loss.
5. Tax gain harvest in 2018, tax loss harvest in 2020.
This is the optimal scenario. The resident would then take the $15,000 in gains in 2018, but would not have to pay any taxes, because he remains in the 15% tax bracket. The resident would then take the $4,000 in losses in 2020 in his first full year as a new attending, earning a 33% tax deduction on the losses, or $1333. The total taxes is a $1,333 gain.
By optimally selling their stocks to take advantage of tax loss harvesting and tax gain harvesting, the resident in scenario 5 who tax gain harvested in the year before graduation and tax loss harvested in his first full year as an attending was able to save $2,983 in taxes compared to the resident in Scenario 4 who sold all of his shares as an attending.
For the medical resident who qualifies (and it turns out that few residents with long-term investment horizons do), tax gain harvesting can be a way to save some money on taxes. Did you use tax gain harvesting when you were a resident?
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