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We’ve been doing a few touch-feely emotive articles lately, so as a change of pace today’s article is going to be about something completely different: Harvesting Capital Gains!
Why Would You Do This
When you own something like stocks, bonds, or real estate that have gone up in value, that’s a capital gain. Unlike interest or dividends which are taxed when you receive it, capital gains don’t become taxable until you realize that gain by selling it.
That makes capital gains special because you can control when you pay taxes on it. If you own an ETF like VTI that has gone up in value, you can continuously defer paying taxes by simply not selling it, and you can watch it grow and grow tax-free, even in your taxable account.
So why would you ever choose to realize capital gains? Well, you can’t delay paying those taxes forever. As I am now realizing after my dad passed away, capital gains get realized automatically at death and this can be quite expensive because it all happens at once.
So, when you have a chance to pay those taxes at a low tax rate, it can make sense to choose to lock that low tax rate in.
Americans pay Long Term Capital Gains (i.e. for assets that have been owned for over a year) according to the following rate table.
Tax Rate | Single | Married Filing Jointly | Married Filing Separately | Head of Household |
0% | $0 to $47,025 | $0 to $94,050 | $0 to $47,025 | $0 to $63,000 |
15% | $47,026 to $518,900 | $94,051 to $583,750 | $47,026 to $291,850 | $63,001 to $551,350 |
20% | $518,901+ | $583,751+ | $291,851+ | $551,351+ |
As you can see, there’s actually a fairly large window where your tax rate for LTGC is 0%. So if you’re FIRE’d and in a low tax bracket, this 0% rate is essentially a tax-free gift from the government every year. It’s also a gift that’s use-it-or-lose-it: If you had available 0% LTGC room and you didn’t realize it that year, it’s gone forever.
The first rule of tax optimization is never turn down free money.
Canadians don’t have as generous a gift from the government for capital gains. All capital gains are taxed at a 50% inclusion rate, meaning that half of your realized capital gains (up to $250k per person) are added to your regular income. The only tax-free income we can make is our personal exemption of $15k per person per year. So, a married couple making no other income can theoretically realize up to $60k of capital gains per year for free, but in reality that personal exemption tends to get used up by your portfolio’s interest or dividend income.
In practice, the goal of Canadian Early Retiree is to realize Capital Gains at as low a tax rate as possible, rather than for free. This means if your side-hustle retiree income can fit within the lowest tax bracket of 15% federally, that’s as good as you can get and you should realize as much as you can at that low rate.
Setting Your Capital Gain Target
The first thing to figure out when realizing capital gains is to decide how much to realize.
Generally, you want to do this process in December. Why December? Because by then you have a good idea of how much money you’re going to make that year. Download all your statements from your investment accounts and add up the interest and dividends that you’ve received in your taxable accounts. Ignore any income received in your tax-deferred (401k/RRSP) or tax-free (Roth IRA/TFSA) accounts since those aren’t reportable anyway.
Then add up any side-hustle income you’ve made for the year, if any.
Total this up and you have a pretty good estimate of your Base Income (BI) for the year. Yeah, I know, you’re missing the December stuff, but close enough.
Now that you have your Base Income, you can see which tax bracket you’re in. For the Americans, look at the LTGC income bracket tables. For Canadians, look at the federal taxable brackets for the year.
Now that we know which tax bracket we’re in, we want to decide whether that’s a good rate to realize. If you find yourself in the American 0% LTGC rate or the 15% Canadian federal rate, definitely use that up as that’s as good as you can get.
If you find yourself at a higher bracket, you have to decide if you’re likely to be in a lower tax bracket in the future. If so, you might want to just skip realizing anything for the year and wait for a more advantageous situation. But if for whatever reason, you’re unlikely to get it much lower (for example, if you have a pension income), you should go ahead and realize it.
Once you’ve made your decision, you need to calculate how much capital gains you can realize to “use up” the rest of the room in that bracket.
Let’s do a few examples.
Say you’re an American retired couple that files jointly. According to the LTGC tables for 2024, you can get a whopping $94,050 of LTGC income for free! After adding up your dividend, interest, and other income for the year, you’re estimating that you’ll be reporting $50k of income for the two of you. That means that the amount you should realize is…
$94,050 – $50,000 = $44,050
You’ll be able to realize this amount at a tax rate of 0%, and as I mentioned before, this room is use-it-or-lose-it, so you may as well.
Now let’s look at a Canadian example, which is slightly more complicated.
The lowest 15% federal tax bracket for Canadians top out at $55,867 for 2024. This is per person, so per couple it would be $55,867 x 2 = $111,734.
Our Canadian couple, after adding up their interest, dividends, and other income for the year estimate that they will also be reporting $50k combined, or $25k each. That means that they can realize
($111,734 – $50k) x 2 = $123,468
Why the x2 multiplier? Capital gains are taxed at a 50% inclusion rate, so you have to double the amount of income you would report in order to figure out how much capital gains you can realize.
While the Canadian couple can realize more, they would have to pay the lowest taxable rate of 15% rather than the 0% the Americans can pay.
It’s Harvest Time!
Now that we have our targets, let’s actually do some Capital Gains Harvesting.
To do this, open up your brokerage account and look at your taxable account. Find a position that has an unrealized capital gain equal to, or greater than the amount you want to realize. Here’s an example of what that may look like.
Symbol | Qty | Average Cost Basis | Price | Open P&L |
VTI | 1052 | $141.8784 | $282.23 | $147,649.88 |
These are the numbers that I yoinked from our taxable account. Note that Questrade calls Unrealized Capital Gains “Open P&L”, which stands for “Open Profit & Loss.” Same thing, different name.
This part is the same process for both the American and Canadian couple, so for this example, I’m going to use the American one and try to realize a gain of $44,050.
In my account, my shares of VTI have an Average Cost Basis (ACB) of $141.8784. That means for each share of VTI that I sell, I will realize a capital gain of
$282.23 (the current market price) – $141.8784 (ACB) = $140.3516
If we want to realize a total of $44,050, we need to calculate the number of shares to sell, like so
$44,050 / $140.3516 = 313.85
We can’t sell fractional shares, so let’s round that down to 313.
Enter an order to sell 313 shares of VTI at current market price. And finally, because we don’t want to change our portfolio’s holdings, we immediately buy back the same 313 shares of VTI at current market price.
We have just realized approximately $44k of capital gains, and our brokerage account should now look like this.
Symbol | Qty | Average Cost Basis | Price | Open P&L |
VTI | 1052 | $183.6370 | $282.23 | $103,719.84 |
We can see that our ACB has now been updated higher, reflecting that we’ve just re-bought 313 shares at the current market price of $282.23, and our Open P&L or Unrealized Capital Gain has been reduced by about $44k to $103,719.84. Our American couple will get a tax slip for this transaction at the end of the year and report it on their tax return, but they won’t have to pay any taxes on it because they were able to realize it for free. FREE!
Oh, and if you’re wondering “Wait a minute, don’t I have to wait 30 days between selling and buying the same ETF?” you’re thinking of the wash-sale rule. That applies only if you’re realizing a capital loss. For capital gains, you can re-buy the asset immediately with no consequences.
Conclusion
So that’s how we strategically realize capital gains. By doing this proactively over time at a tax rate we choose, we can prevent a future situation where you have a massive capital gains tax bill later on.
It’s fun, isn’t it? Well, I think it’s fun.
Do you also harvest capital gains every year? Why or why not? Let’s hear it in the comments below!
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If I’m looking at your example of selling and then buying VTI, why would a Canadian do it?
For this action a Canadian at the lowest bracket will pay 15%, just to have no extra free cash to use for the year and the same portfolio value and holdings. Sure, we changed our ACB for future years a bit higher, so we will pay less tax in the future (potentially), but it comes at a cost of (minimum) 15%.
I’m just wondering if there is a concrete example of when it is worth it for Canadians, as opposed to just leaving it alone.
In a way, you can think of this strategy (for Canadians) as having a 15% friction on this portion of the portfolio. Almost akin to a higher MER in exchange for potential lower future tax.
I have the same question. I don’t understand why it’s not just better to leave the investment alone.
Because paying tax at a lower rate now is still better than paying a higher tax rate a later date.
It’s not about paying zero tax all the time. It’s about paying less tax over time.
You play with the system you have.
I’m planning on doing this either this year or next. My income is in the process of decreasing as work becomes more and more part time.
Where did you find $94,050?
irs.gov/taxtopics/tc409 says its $89,250.
Also, remember $29,200 is the standard deduction in 2024 for married filing jointly.
My and many others situation is complicated by ACA subsidies, determined by MAGI.
Andrew,
You are in the same boat as we are. To complicate it more, in 2025 I switch from ACA to Medicare. As you stated, ACA is calculated on the MAGI which is based on the whole years income, not the 4 months I will have to use it. We have to stick with ACA as I transition over to Medicare because of the lifetime penalty charges they stick us with if I were to skip insurance for any duration before Medicare. Add in that my previous employer has to either pay me a lump sum amount for my Cash Balance Plan or I have to chose an Annuity. This will make next year interesting.
Not everyone’s picture is complicated but many are. Thanks for mentioning the ACA challenges.
Wanderer, thanks for bring back the technical side of investments. These reminders or lessons are great!
+1 to the ACA considerations that Americans younger than 65 face. ACA is basically a parallel tax. If I didn’t manage my realized income appropriately, my health insurance cost would run about $22k annually, and that’s just for the insurance, not any doctor visits or procedures. I would love to be doing some Roth conversions, but I’ll have to do them after I hit 65, or get hit twice with ordinary taxes and 22k of health care insurance cost. I wish I could fill up that 0% bracket, but it would cost too much in lost ACA subsidies.
Would you mind sharing the range you try to keep your realized income? We are one of those people spending $25k a year on health insurance. It seems to me that any household income over $100k does not receive ACA subsidy.
Our income is about 50k, but our spending is closer to 100k. The difference comes from savings/cash/cost basis of capital gains. ACA is based on income, not assets, so you have to have enough stashed in after tax accounts to make up any difference between your income and spending. That’s why you don’t put everything in tax deferred accounts, so you have enough flexibility to manage your income to max out ACA subsidies. If we had to pull all 100k out of our IRAs, we would get very little (if any) subsidy.
I see the advantage of an American doing this. But for a Canadian, if we need to pay this 15% federal tax right now, I’m curious is this more efficient than investing the money you would use to pay these taxes and letting that compound. Would you make more money from this compounding over a few years and potentially paying a slightly higer tax rate on capital gains in the future. Obviously case by case it would be different as different people live off different amounts for a lot of FIRE enthusiasts a lot of us can live off that number or less within that 15% bracket in the future.
I agree, I think Canadians need to take the time value of money into consideration. While the article is correct that Canadians would pay in total less tax by doing this capital gains harvesting, Canadians would have less cash available to invest due to pre-paying the capital gains taxes. Jamie Golombek has some good articles on this concept, and his general advice is that its better to pay tax later, even if you have to later pay tax at a higher tax rate. I think if you are dealing with short time horizons (eg. you know you will need to trigger capital gains in the next 5 years or less), then capital gains harvesting is a good idea in Canada to ensure you fully utilize low tax brackets
My friend has been pushing covered call options on me for 2 years when i finally got it. VTI offers these. Cash…today. NOW! Conservatively you can add a little (and it adds up) with basically no
risk. As long as you’re holding it anyway, why not?
(Just a suggestion)
DYODD.
Covered calls reduce your upside return (even with far OTM options), while exposing you to nearly the same downside risk as the underlying. Overall, worse risk-reward ratio than plain stock.
Psychologically, it’s appealing to see cash from premiums build up, but that’s really just being pulled out of future returns. There is no riskless return unfortunately.
As of June 25, 2024, the Canadian capital gains inclusion rate changed to 66.67% on any capital gains over $250,000, did it not? So that would make a difference to some.
Also, it seems that if you do work on realizing capital gains when you’re at a lower tax bracket, you would also be working on realizing capital losses to offset those gains. But you can’t, as pointed out, just repurchase those assets sold at a loss. So it becomes quite a bit more complicated.
In America, there a step up in basis for inheritance investments. Please explain your reasoning pertaining to your late father. It’s confusing. The remainder is fine an Awesome. You’re truly special. Thanks.
If there would ever be a single reason for moving to Belgium, it’s probably this.
Taxes on capital gains are 0.12%, as long as they come from stocks (including ETF’s that are holding only stocks). I retired early on an accumulating MSCI World ETF and pay myself from my portfolio on a monthly basis (no transaction fees either). Love it!
Don’t move here before you have the money though..income is taxed higher than anywhere in the world. Cheers!
I understood all of this except the part where you buy back the shares you just sold. Why? Isn’t the point of selling to have money to live on, or whatever? I understand you’re selling at a tax advantage, but you still have no money on hand. Sorry for my ignorance.
The point of this article was how to avoid paying a large amount of capital gains tax by doing annual sales within the lowest tax bracket. This principle is independent of any withdrawal plan, though, there is no reason I can see for not also considering this withdrawal as part for living expenses – this is exactly what Ed Rempel recommends , what he calls a self-made dividend.
In your example where you sell VTI and get a cap gains of 44k USD… If you are Canadian and harvesting for capital gains purposes you would have to make one further calculation which would be converting the the shares value from USD to Canadian on the date / year of purchase and the date / year of sale. Then you would have your final Capital gains in Canadian Dollars.
I’ve been using the tax harvesting strategy for a while now. However, rather than simply selling and repurchasing the same stock, I also use it as an opportunity to rebalance my portfolio.
Initially, I focused on selling the shares with the highest capital gains—those with the largest difference between the current market price and my purchase price. But lately, I’ve been reconsidering that approach. I’m starting to think it might be wiser to sell the shares with the lowest capital gains instead. This way, if the market takes a sharp downturn, I’ll still have the flexibility to sell the ones I bought at the lowest cost. It’s a way to further protect myself from potential losses, especially since I remember Warren Buffett’s advice: “Rule #1: Never lose money. Rule #2: Never forget rule #1.”
I could be mistaken, but I believe you should investigate “Step up basis”. In the US, basis used to determine capital gains is reset when inherited, so rather than having a big bill when someone dies, you would have no bill.
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