Tax Gain Harvesting on Fixed Income Positions
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
The usual story around capital-gain harvesting is to take advantage of the zero-capital gains bracket (on income up to $39,750 per year) by selling some appreciated investments. This works for people with low to moderate income. However, the sharp decline in interest rates this year has created the opportunity to realize tax savings on appreciated fixed income positions even when clients are in a high tax bracket.
The strategy starts with the insight that when a bond increases in value it is an accelerated recognition of cash flows. The actual cash flows are unchanged. On a pretax basis, there is no economic difference between holding the appreciated bond to maturity or selling it and reinvesting the proceeds in a bond with the same yield, maturity date and risk.
This is not true on an after-tax basis.
Bond interest is taxed at ordinary tax rates. The gross return (payoff) after taxes on a bond purchased at par is:
RAT = P (1 + C(1 – TORD))N
where RAT is the after-tax gross return, P the principal invested, C the coupon, TORD the ordinary tax rate and N the number of periods.
For example, assume an investor is in the 37% ordinary tax bracket and 20% capital gains bracket. When bought at par, a five-year, 5% bond with semi-annual coupon payments has an after-tax expected gross return of:
$1,169 = $1,000 (1 + 0.025(1 – 0.37))10