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When to Tax-Gain Harvest Your Bonds

Last week’s article about tax-gain harvesting with bonds drew quite a bit of correspondence from readers. (To recap, the general idea is to sell a bond that has increased in value since you bought it — and which you have held for more than one year — and reinvest the proceeds in a similar, newly-issued bond with a comparable remaining maturity. In doing so, you effectively convert some of the interest income into long-term capital gain income, which is often advantageous due to the fact that long-term capital gains are taxed at a lower rate than ordinary income.)

The primary question readers had was: Are there cases in which it would not make sense to use such a strategy?

And the answer is that, yes, there certainly are some cases in which it wouldn’t make sense to tax-gain harvest your bonds.

For example, the desirability of the strategy depends on what type of bond we’re talking about.

  • It is most likely to make sense with corporate bonds,
  • It is less likely to make sense with Treasury bonds, because the interest on Treasury debt is free from state income taxes, whereas the capital gain income would, in most cases, be taxable at the federal and state levels, and
  • It is almost never going to make sense with muni bonds, because muni bond interest is tax-exempt at the federal level, whereas the capital gain income would be taxable at the federal and state levels.

In addition, there’s the possibility that something else tax-related would make you want to avoid increasing your income this year. For example, if there’s a particular tax credit for which you currently just barely qualify, but the capital gain would push your income over the eligibility threshold, tax-gain harvesting this year is unlikely to be advantageous. Or, if you’re a retiree collecting Social Security, and your income level is currently at a point where your Social Security is nontaxable — but realizing a capital gain would push you into the range where a significant portion of your benefits would be taxable this year — that’s a point against tax-gain harvesting.

In general, the analysis that you want to do is figure out how big the tax increase would be this year (due to the capital gain income) and how big the savings would be in future years (due to the reduced level of interest income). To get the best analysis possible at a DIY level (i.e., without paying a professional to assess the situation for you), it probably makes sense to do a test-run through TurboTax (or something similar) comparing each approach (selling vs. holding) for the years in question.

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