In this blog series, “Advanced Financial Independence Tactics”, we jump into the super smart, pretty advanced tactics that someone can use as part of their life during, and prior to, Financial Independence. These tactics will revolve around cutting costs, avoiding taxes, improving savings, and more. If we wanted to blend these posts together into one purpose, that purpose would be to optimize the steps you are already taking so you can improve your likelihood of staying financially independent forever. Enjoy the crap out of the information, because much of the information won’t really be talked about outside of the realm of the Financial Independence, Retire Early community.

As the title says, we are covering Tax Gain Harvesting and Tax Loss Harvesting. For most of you, the first question to answer is “What the crap is that?”.

Well, when someone has a large amount of invested assets (or even a smaller amount), those assets are going to be divided into three main categories based on their taxable potential. Because of this, and because of your goal to retain as much of your money as possible (and avoid giving much of your hard earned dollars to the tax man), we want to focus on optimizing each category and your total investment portfolio.

The three tax categories of investment asset are:

1. Taxable Investments.
2. Tax Deferred Investments
3. Tax Free Investments.

Tax Gain Harvesting is the focus of steadily increasing your cost basis in your investments in a way that decreases the likelihood of you paying much tax on the investments when you take them out. Tax Loss Harvesting is the opposite, it includes taking purposeful losses on your investments by selling them when the market drops so you can write off losses and lower your taxable income each year after. Therefore, the category that these strategies are going to affect are your taxable investments (obviously). Your tax deferred accounts (401ks, IRAs, TSPs, etc.) will have 100% of the funds within the account taxable at withdrawal because you took the tax deduction up front when investing the money. So, there is no need to focus on cost basis to any real extent. Tax free investments, primarily noted through your Roth accounts, are not taxable when you withdraw the money from the account after 59 1/2, and do not need to have concern around any tax burden. Between these three options, you can withdraw differing amounts as you need in order to provide yourself the lowest tax possible.

But, this conversation is talking specifically around your taxable investment accounts within a brokerage account (because you can control the taxes most here). Most people will have Mutual Funds, ETFs, Stocks, Bonds, and REITs within these brokerage accounts, and most people will use the large brokers such as Fidelity, Schwab, Vanguard, and others to hold their investments.

For our example, let us say that someone has $1,000,000 in investment accounts, of which $500,000 is invested in a standard, taxable brokerage account. For simplicity sake, let’s say all $500,000 is invested in a single Mutual Fund like Fidelity’s Total Stock Market Index Fund. The other $500,000 is invested 50/50 in a traditional IRA and a Roth IRA. We will also keep this simple and use tax brackets based on someone who is married and filing jointly, is under 65 years old, and has no kids. If you are unmarried, over 65, or have kids, these numbers will change around. Regardless, it is recommended in every situation to consult your tax specialist in finalizing your plan prior to withdrawing funds.

What we next need to breakout is how the tax code is going to tax your investment (and other) income. Many of you have seen the tax brackets before, but most people don’t understand how they work or how investment income is treated. Here is a quick snip of the 2024 married filing jointly tax brackets for both ordinary income and long-term capital gains income (shown as “LTCG Tax Rates”).

The first thing to note comes with the standard deduction. You can see above that the standard deduction for a married couple adds up to $29,200 (for 2024). This $29,200 is used to reduce your taxable income that you show. So, for instance, if you made $29,200 in ordinary income from a W2 job, after your standard deduction of $29,200 is taken into account, you would show zero income and have no income taxes to pay. Make sense?

Long-term Capital gains are any profits you made from the sale of investments or other taxable assets above what you paid for them, with an asset or assets that you have owned for longer than 1 year. Short-term Capital gains are profits you made from the sale of investments that you have owned for less than 1 year and are taxed as ordinary income like your W2 wage.

Hopefully, you notice that you can take out quite a bit of money (up to $94,050) on long-term capital gain income and other income before you have to pay any income tax on the long-term capital gains income. This can make this income a very tax advantaged income, depending on how you set up your finances.

Let’s use two examples quickly to show the differences in the income tax breakdowns between ordinary income, tax free Roth income, and long-term capital gains income.

1. Let’s say someone took out $123,250 from each of their different tax category investment accounts, 1 different account type each year, and had no other income sources (quick note, taking out that much for actual income likely would not make sense in regards to the long-term likelihood of your assets lasting your lifetime, because taking out that much is a very large withdrawal rate and would likely have you run out of money faster than you want. We are using this dollar figure solely to have you understand the tax differences of the three account types and assume any extra income would be LTCG income that is reinvested in the funds. Following the 4% to 5% safe withdrawal rate ranges is still very much recommended.).
   • Based on the above tax code, if someone took all $123,250 out from their Roth IRA (after 59 1/2), none of that money would be taxable (because the Roth is a tax free account), so that individual or couple would pay $0 in tax that year. Simple stuff. This would not be smart to do, as it would use up a huge percentage of this person’s tax free funds. But, math wise, figuring out the tax is simple. It is zero.
   • If someone, instead, took out the full $123,250 from their tax deferred account (we will say it is a traditional IRA), they would then have to follow the ordinary income tax brackets. You can see above, that $123,250 is in the 22% tax bracket, but first we must take out their standard deduction. After removing the $29,200 from the $123,250, they would show income of $94,050. This would lower their brackets to 12% maximum. But remember, the full $94,050 is not taxed at the 12% bracket. The first $23,200 is taxed at 10% (so $2,320 of tax) and then the remaining $70,850 would be taxed at 12% ($8,502 in tax). So, in this scenario, this couple would take out $123,250 and pay $10,822 in taxes for that income (which is a real tax percentage of 8.78% of their income). Still pretty low for that much income, but we can get lower with the tax free (Roth) account and in our example below.
   • Finally, if someone took out the $123,250 from their taxable account and all of the money was long-term capital gains, their tax requirements would go like this. First we would subtract out the standard deduction of $29,200, so they would show long-term capital gains income of $94,050. Since they have no other income, and you notice the long-term capital gains tax bracket says any total income of less than $94,050 would incur a 0% tax rate on long-term capital gains, this individual would therefore pay $0 in taxes in this scenario, also.

Isn’t that sweet? In all three of these scenarios of someone only living off their investment incomes, and taking out $123,250 of “taxable” income, only one scenario would that couple have to pay any taxes, AT ALL! This is part of why wealthy people who are living off their investments pay so little in taxes. And guess what, you can do the same thing!

What if you did have someone who made a W2 income of $40,000? How would that change things? Well, in that instance, they will have to pay taxes on that W2 wage because it is larger than their standard deduction. But, they could optimize their options here to get low tax rates and still total income of $123,250 again (if they wanted). Let’s break it out.

1. They Make $40,000 of W2 income.
2. Let’s say we then have them take out $12,400 from their IRA, and $70,850 from their taxable brokerage.

The math would go like this:

1. They would show $123,250 of total income.
2. Their ordinary income would be their W2 wages plus their IRA withdrawals, which adds up to $52,400.
3. You minus the $29,200 from the $52,400 which gives them ordinary taxable income of $23,200. Based on the tax brackets above, they would then owe 10% tax on that income ($2320).
4. We would add the $70,850 to the $23,200 and that would give them total taxable income (after the standard deduction) of $94,050. If you remember, as long as we show $94,050 or less of taxable income, any long-term capital gains are not taxable. So, this person would show $0 of tax on the long-term capital gains income.
5. In total, with $123,250 of income (of which 40k was W2 income, and $12,400 was IRA income), this couple still only paid $2320 of total tax, which equals a tax rate of 1.9%. BOOM!

Crazy stuff right? Think of all the taxes you pay at your normal W2 job, and then compare it to the taxes you could be paying if you just had enough assets invested to live off of. So much money could be saved.

But, here is the other crazy part. If that couple didn’t need the full $123,250, they could then reinvest that money (whatever they didn’t need from the investments they sold) back into the same Mutual Fund they had previously. Why would they do that? Because they are buying it at a higher price than they previously did prior to selling the funds, which means when they sell those funds again next year, they would have a smaller gain and less tax burden because their cost basis in the fund increased. That would then also mean they could take out more funds for less capital gains tax in the future. If they do this every year (more than 12 months apart so it is long-term capital gains), they can keep their actual capital gains exposure very low and reduce their likelihood of a tax burden. This is called Tax Gain Harvesting.

On the flip side, lets say the year after they originally harvested the gains the market drops 10% (which puts their value of the investment funds less than where they bought them). At that point they could again sell their funds, but this time for a loss, and write off those losses ($3000 of the losses each year moving forward) to lower what they show in taxable income even more. This is called Tax Loss Harvesting.

In reality, if you understand these tax brackets and tax codes, and you take the time to strategically sell your taxable investments during the year (more than 12 months apart if you sell with a gain), you can decrease the taxes you have to pay even further. For many people, they routinely can set themselves up to not pay taxes ever again because they show almost no gains and their standard deduction wipes out any ordinary income from IRAs, etc.

How is that for cool? Want to keep more of your money and save yourself 10s of thousands of dollars or more? Use these tactics and pay way less taxes every year. Finance Nerds Unite!

Also, for something completely unrelated to this post, enjoy one of the 2024 “Best Science Images” –